Why You Diversify

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by: Charlie Bilello

Concentration: the fastest way to build wealth and the fastest way to destroy it. To have any chance at "getting rich quick," you need to hold a concentrated portfolio. But chance is the key word in that sentence, for you may instead get poor quick.

Concentration risk isn't limited to holding a single security. It can also come from holding a single currency, geography, industry group, sector, or asset class.

At the sector level, concentration can giveth and it can taketh away. We have seen two prominent examples of this in recent history…

  • On March 27, 2000, Technology stocks (NYSEARCA:XLK) peaked. From there they would fall 82% until finally reaching a bottom in October 2002. Nearly seventeen years later, they remain below their 2000 peak.

  • On May 31, 2007, Financial stocks (NYSEARCA:XLF) peaked. From there they would fall 83% until finally reaching a bottom in March 2009. Nearly ten years later, they remain below their 2007 peak.

Both Tech and Financials are now less than 2% away from hitting new all-time highs. Their recent strength has been great news for the overall stock market as these are the two largest sectors in the S&P 500.

If one knew nothing about markets, they might assume that the S&P 500 is also approaching long-awaited new highs. But that is not the case. Following the 2007 through 2009 bear market, the S&P 500 (total return) has hit 200 new all-time highs, with the first occurring back in April 2012. In 2017 alone the S&P 500 has already hit 15 new all-time highs.

How is that possible with its two largest sectors still below their all-time highs from 2000 and 2007? The other sectors have taken up the slack. While the weightings of Technology and Financials have declined from their 2000/2007 peaks, the combined weightings of the other sectors have moved higher.

Why You Diversify

The lesson here: concentration cuts both ways. It can build wealth and it can destroy it. Investors who held concentrated portfolios in Tech and Financials back in 2000 and 2007 assumed that risk with the goal of "getting rich" quick. After 80+% drawdowns, they learned that there is no guarantee of success. Today these same investors are simply hoping to "get even" and at long last are close to getting there.

There is another choice, of course, but it requires giving up on the dream of "getting rich quick" and admitting that you can't predict the future. That choice is attempted to get rich slowly through diversification.

The diversified investor over the same time period experienced a much more tenable path. From the peak in Tech in March 2000, the S&P 500 (total return) has hit 247 new all-time highs, and is up over 117%. From the peak in Financials in May 2007, the S&P 500 (total return) has hit 207 new all-time highs and is up over 92%. Importantly, these returns were achieved with lower volatility and a much lower maximum drawdown (55%) than a portfolio concentrated in Tech or Financials. This is important because it increases the likelihood of an investor sticking with it. If you add in bonds and other asset classes since 2000, the return/risk profile continues to improve as does the chance of an investor staying invested.

Some might take issue with the decision to diversify, asking "who could have predicted" the twin crashes in Tech stocks and Financials. Their implication is that the negative outcomes in these sectors were simply bad luck that no one could have foreseen. Perhaps, but that is precisely why you diversify: because you can't predict the future. If you could predict it, you would put all your eggs in the best basket. Since you can't predict it, you put an egg in every basket.

There will always be stories of investors getting rich quick through concentration, which is why the allure is so great. But as we have seen here, concentration cuts both ways, and there are just as many stories of financial ruin through concentration. The evidence suggests the vast majority of investors have a higher chance of building long-term wealth through diversification. In diversifying, you are simply putting the odds in your favor. That doesn't mean it's easy to do or stick with, for it means admitting to yourself and others that you cannot predict the future. When you are ready to admit that, you are ready to succeed in markets.

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