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The strategies that increase the odds of achieving investment success too often get a bum rap. Drowned out by the advice du jour, financial prudence is forever getting trampled in the latest news cycle as more enticing notions grab the crowd's attention. Buy this, sell that. Oh, look, XYZ Corp. posted an unexpected rise in earnings last quarter. But, wait, look over there: same store sales are down and look at Uncle Billy's Medical Supply Inc.

So it goes in the 21st century, which is awash in investment advice, analysis and outright guessing. Some of it's okay, most of it isn't, and only a small minority of it's worthy of being enshrined as enduring principles. On Tuesday, your editor stumbled across a column of questionable value published by one of the major outlets in the so-called new media. The basic message: mutual funds are for those who don't know any better. It is far better, the column recommended, that investors pick a handful of stocks and forget about it. Not just any stocks, of course, but those that have durable brands and businesses that will stand the test of time, and that are selling on the cheap. In short, you don't need a mutual fund.

The rationale given is that Warren Buffett doesn't use mutual funds, and so neither should you. In fact, the author quoted Buffett directly, lest there be any doubt of the true road to investment success: "Diversification is a protection against ignorance."

Of course, investing isn't quite so simple. For starters, Buffett has also gone on the record as saying that index funds are a pretty good investment after all. Earlier this year, the Oracle of Omaha advised that, "A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money." The strategies that increase the odds of achieving investment success too often get a bum rap. Drowned out by the advice du jour, financial prudence is forever getting trampled in the latest news cycle as more enticing notions grab the crowd's attention. Buy this, sell that. Oh, look, ABC Corp. posted an unexpected rise in earnings last quarter. But, wait, look over there: same store sales are down.

To be fair, the columnist we cited above also recommended passive investing in the form of broad ETFs, although he qualified the advice by suggesting that indexing was most appropriate for greenhorns.

But let's go back to the first quote from Buffett, the one about how diversification's only relevant if you're ignorant. In fact, we couldn't agree more. And let's be clear about one thing: mere mortals are ignorant on the most important variable in the investment universe: the future.

No amount of analysis of the past (which is the only analysis we have), and extrapolating into the future can divine what's coming. Yes, it's true that studying history and gaining perspective on where the markets have been is useful, if not necessary, for becoming an informed investor. But the future is ultimately mysterious, and that mystery generates a massive amount of risk. Most of the time that risk looks benign, even friendly. Looking back over the past five years suggests that there was little point to diversification. If only we'd known! But we didn’t. Nor do we now. We can guess, we can speculate, we can confidently project that company A's real estate holdings will be valued higher next year, or that it's new widget will grab a 50% market share overnight. But we don't know, and we'll never know until the future unfolds.

Risk, of course, is a good thing, if you exploit it intelligently. For some, the definition of "intelligently" varies far, and wide. For our money, owning a broad mix of betas (stocks, real estate, commodities, etc.) and managing those betas (i.e., adjusting the weights) is the only game in town. Why? Because of that risk thing, which tends to pop up at the most inconvenient times. Indeed, if we knew what was coming, we wouldn't need diversification.

But in the real world, one has to balance greed with fear. And the challenge is even more complicated by the fact that humans make mistakes. Even intelligent humans. Yes, that includes Warren Buffett. Remember his investment in U.S. Airways in 1989? Not exactly his finest moment. Fortunately, he was diversified.

Of course, we're second to none in recognizing that Buffett is arguably the best stock picker the world has ever known. But we only know that by looking at the past, and so it's easy to point to Buffett now and say, do what he does. Would you have said that in 1970, when Buffett was relatively unknown and far less tested, at least by his current iconic status? Maybe, maybe not. As a test, who's the new Warren Buffett? Do you see him? You do? If so, how much of your net worth do you plan on giving him? Well, take your time. Maybe you'll want to think this over for a while.

Yes, for the truly gifted investors diversification is of limited value. You know who you are. But as a general rule, most of us are mediocre or worse, at least when our investment results are measured over the long term, and we factor in taxes and expenses. As such, it's best to keep investment costs low, defer taxes, and diversify. That's easy by owning a multi-asset-class portfolio built with low-cost index mutual funds, and/or ETFs. If you think you're smarter than the average investor, maybe you'll play with the asset allocation a bit more than most. You might even indulge in tactical strategies such as portable alpha, shorting and leverage, all of which can be facilitated with ETFs, and index mutual funds.

But if you're not confident that you have what it takes to be an exceptional investor over the next 20 years, or you simply don't want to spend the time, effort and risk testing the idea with real money, Mr. Market's asset allocation across broadly diversified betas of stocks, bonds, real estate and commodities will do pretty well over time. One reason is that a prudently diversified portfolio will almost certainly never lose massive amounts of money over time, or collapse into dust because of some unexpected crisis. Asset classes don't go out of business. Avoiding that risk is more than half of how you win the money game.

Yes, you might be able to achieve more by picking individual securities. But before you do, ask yourself: am I an extraordinarily talented investor? Not sort of talented, not slightly talented every now, and again. But over time, and in moments of crisis as well as soaring bull markets. Warren Buffett clearly is. Are you?

Source: Risk and Investments: Diversification's the Name of the Game