The Case Against Diversification and Holding Cash

by: J. S. Kim

Diversification, cash and AAA-rated instruments with exposure to Mortgage Backed Securities – If you’re deep into all three, these are three definite signs that it is time to let your advisor go. Many “professional” advisors today argue that diversification is a reason to stay fully invested through bear markets. After all, if your advisor had diversified your portfolio into a bunch of housing and financial stocks that are all sitting on 40% to 70% losses right now, he or she would probably tell you that the bottom is certain to be near and that the worst performers of your portfolio this year will be the best performers of your portfolio in the years to come. Well, here’s a news flash. The time to sell out of these stocks was 9 months ago, and if you’re still holding on, the odds are that you will be hurt even more.

Here’s the reality. Diversification is the world’s worst investment strategy and has only served to erode a great deal of net worth and purchasing power for both Americans and Europeans alike. During the past 8 years, many of the major indexes in these regions are negative on an inflation adjusted basis. Thus, for 8 years of buying and holding, if your money was invested in funds pegged to the S&P 500 or the FTSE 100 (and 98% of money managers peg their portfolios to the major indexes of their home country), your net worth has been significantly eroded.

The Warren Buffet Argument is a Sham

Financial advisors often praise the benefits of diversification to advocate a buy and hold strategy so that they can continue to earn fees on depreciating portfolios during bear markets. To convince you that doing this very wrong thing is the right thing to do, they utilize the Warren Buffet argument. They argue, “Look at Warren Buffet. He’s a buy and hold guy and he’s one of the richest men in the world”. In a rational world, such an argument would be called a selective reconstruction of reality. What these same money managers fail to tell you is that Warren Buffet built his wealth by concentrating his exposure, not through diversification. At times, Mr. Buffet has held a mere five positions in his entire Berkshire Hathaway equity portfolio. Mr. Buffet did not diversify, because with his level of expertise, there was no need to do so. Mr. Buffet can buy and hold because he is concentrated in positions that will continue to do well whether markets are bear or bull markets.

That’s what anyone that knows what they are doing will do. In bull markets, financial advisors that truly are on top of their game will concentrate to outperform the markets significantly. In this case, since a rising tide lifts all boats, those that choose to diversify can conceal their incompetence as they earn money simply through luck. However, in a bear market, incompetence is much more difficult to hide. As very few asset classes will make money during this time, the need to concentrate becomes critical to one’s financial survival. In bear markets, diversification is revealed for what it is – a pure sell-side strategy of the commercial investment industry.

The Foibles of the Cash Argument

This brings me to my next point. Over the past couple of months, I’ve seen many financial consultants circulate articles advocating holding cash as undoubtedly the best strategy in this extremely volatile market. They claim that cash is king for “no one can be sure exactly what the market is going to do.” Thus, they advocate a “wait and see” approach before displaying a willingness to commit to a clear plan for your money. Here again, is why the argument for cash is an argument for incompetence, just as is the argument for diversification.

The current U.S. bear market has been so unfailingly clear for months on end, that on February 5th, I penned an article titled “Is a Recession in the U.S. Coming? We’re Already in One” right here on my investment blog. For anyone willing to dig even slightly below the surface, the direction of the U.S. economy has been as clear as a two-ton boulder falling out of a clear blue sky. In this article, I warned investors as bluntly as I could of the imminent dangers in the U.S. markets by stating: “Anyone out there really think that changing a few numbers here and there won’t change a negative GDP rate into a barely positive one fairly easily? But we need two quarters of negative growth rate for an “official” recession don’t we? Ok, then wait until next June, counting on a bull market to arise from the ashes, and see if this belief won’t cost your stock portfolio dearly.” Backing up my assessment, one month later, Warren Buffet also made the same declaration of the U.S. being in a recession despite the lack of support from “official” government numbers.

In addition, anyone that understands to the slightest degree the explosive growth of the financial derivatives market understands that Asian markets cannot yet be fully “decoupled” from U.S. markets, and that in fact, global stock markets are intertwined to a higher degree than at any other point in history. Here, financial consultants that advocate cash are merely waffling to conceal their lack of understanding of the global economy.

When the Odds Overwhelmingly Point in One Direction, Play the Odds

So here is my point. When the odds so overwhelmingly favor a major downturn, to play the odds is not risky. As subscribers to my Global Stock Picker investment newsletter well know, I took a firm stance in this regard by double-weighting positions in our model portfolio that have been benefiting tremendously from this current downturn. These two positions are now sitting on weighted gains of 17.03% and 56.21% now. If I couldn’t determine the likely direction of markets and consequently stayed on the sidelines in cash, we would have given up the above gains. In bull markets, truly significant rewards will be reaped only by those that have the foresight to invest in certain stocks and asset classes well ahead of the thundering sheep herd. Likewise, on the downside, if one waits on the sidelines in cash until after markets have already plummeted substantially, then the significant gains on the downside have already been lost.

Cash Equals Incompetence

Thus I can only conclude that an advisor that advises you to sit mostly in cash for long periods of time is taking this strategy to compensate for his or her incompetence. He or she has no idea of whether the markets will go up or down, and fearing an egregiously wrong decision, elects to stay in cash. Remember that if you have an advisor, you pay the advisor to determine whether markets will go up or down, not to waffle like a politician.

One must remember that risk only comes from not knowing what you are doing. Recently, Warren Buffet declared that if you are unsure of yourself, then perhaps diversification is the best strategy for you. If you are unsure, then perhaps cash is the best strategy for you as well. Personally, I believe that if you can’t confidently concentrate your portfolio, you shouldn‘t be in the game, period. Why be in the game if you have no idea what you are doing, or if you have an advisor that has no idea what he or she is doing? If you are at this stage, then you are gambling with your money, not investing.

Last month, in February, it was reported that leaders from the G-7 nations (the United States, Canada, Japan, Britain, France, Germany, and Italy) met in Tokyo to discuss collective action “to calm markets, if price moves become irrational.” Finance ministers and central bankers from the G-7 agreed that if there are “irrational” price movements in the markets, that they would “collectively take suitable measures to calm the financial markets.” Furthermore, they stated that markets will not be forewarned of such action, “otherwise it will lose its effect if it is explained.” Given that the G-7 Finance Leaders admitted that their actions behind the scenes would “lose its effect if explained”, to me, this is a clear admission that their efforts involve manipulation rather than solid fiscal policy. If their efforts consisted of anything remotely fiscally sound, than explaining it should not cause the objective to lose effectiveness.

Now the only scenario in which it is plausible or reasonable for someone to ever advise you to sit in huge sums of cash is when he or she fears surprise market manipulations that could cause markets to turn on a dime. For example, if an advisor studied these comments from the G-7 Finance Leaders and feared that the U.S. Federal Reserve might make an emergency interest rate cut of 100 basis points tomorrow, then sitting on the sidelines in cash would be apropos as a whiplash reaction to such actions could wreak temporary havoc on even intelligent strategies. Such manipulation could change the investment environment in a hurry, even though the effects of such manipulation would most likely only damage short-term bets and not any investments predicated on a solid understanding of the long-term global economic outlook. However, I have yet to encounter this argument among the numerous articles that advocate sitting in cash now; instead, the authors point to technical analysis or economic data that should never be taken at face value nor analyzed on a singular basis given the circumstances we face today.

AAA? What Does it Really Mean?

Finally, a brief closing word about credit ratings these days. Agencies such as Moodys and Standard & Poors are paid by the very financial institutions whose financial instruments they rate. If they don’t grant the ratings the financial institutions desire, the financial institutions don’t pay them. Think you can trust that the “AAA” rating on your bond won’t get downgraded to “B” overnight? Think again. If you own “AAA” rated bonds or even Money Market Funds that have exposure to Mortgage Backed Securities or other Collateralized Debt Obligations, you better do a lot more homework to ensure that they are indeed “AAA”. Nowadays, in my eyes, these ratings are almost completely worthless and meaningless. In conclusion, if your advisor has you engaged in a diversification strategy, has you sitting in lots of cash, and has purchased “AAA” financial instruments with exposure to MBS and CDOs for you, it’s most definitely time to re-assess your strategy going forward.

Whether markets are bad or good, a competent advisor can earn lots of money for his clients. It is a total myth that during poor and challenging markets, because all your neighbors are losing money, that you have no choice but to suffer the same consequences. In fact, in extremely poor markets, a competent advisor can build wealth for you even more quickly than in bull markets.