Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

[wabmester]

My definition of diversification:   A method to guarantee you'll have mediocre returns.

Perhaps a couple of examples would help you.

Which is smarter: a) buying a single junk bond yielding 10%, or b) buying a 100 junk bonds with an average yield of 10%?

The obvious answer is (b).   If your single junk bond fails, you are hosed.   If a few of your 100 junk bonds fail, your yield drops a little bit, but you are shielded from catastrophic risk with almost no loss to your upside.

Which is smarter: a) 100% stock portfolio, or b) a mix of stock, bonds, and real-estate?

Stocks historically have the highest long-term return, but even if history is your guide, the (b) combination can give you the same or higher returns with lower volatility.   This is the magic of negatively correlated volatility, and it's considered the only "free lunch" in investing.

 

[justin]

azanon,

Consider this syllogism:

Volatility is a type of risk.

By your admission,

... It [diversification] lowers volatility...

Therefore, diversification lowers the portion of risk due to volatility.

 

[Gone4Good]

Perhaps a couple of examples would help you.

Which is smarter: a) buying a single junk bond yielding 10%, or b) buying a 100 junk bonds with an average yield of 10%?

The obvious answer is (b).   If your single junk bond fails, you are hosed.   If a few of your 100 junk bonds fail, your yield drops a little bit, but you are shielded from catastrophic risk with almost no loss to your upside.

Wab, obviously you just don't get it.  Instead of splitting up all your money into 100 junk bonds for a lousy 10% return, you simply pick the one bond at 20 cents on the dollar that you KNOW is going back to par for an easy 5x on all your money.  Investing is soooo easy.  

 

[wabmester]

The only way diversifying with assets of zero correlation get you the same or higher return is if the asset you add has an equal or higher mean return.  Adding a lower returning asset can only lower variance and total return.

What you say is true for assets with positive correlation, but is not true for assets with negative correlation.   You can actually juice the returns by adding a negatively correlated asset with lower average return.

Maybe it's time for a trip to gummy-world:

What Gummy says

Of course, correlations change with time, so the best allocation in the past won't necessarily work so well in the future.

 

[brewer12345]

Perhaps a couple of examples would help you.

Which is smarter: a) buying a single junk bond yielding 10%, or b) buying a 100 junk bonds with an average yield of 10%?

The obvious answer is (b).   If your single junk bond fails, you are hosed.   If a few of your 100 junk bonds fail, your yield drops a little bit, but you are shielded from catastrophic risk with almost no loss to your upside.

Which is smarter: a) 100% stock portfolio, or b) a mix of stock, bonds, and real-estate?

Stocks historically have the highest long-term return, but even if history is your guide, the (b) combination can give you the same or higher returns with lower volatility.   This is the magic of negatively correlated volatility, and it's considered the only "free lunch" in investing.

Unfortunately the world is rarely that simple. The choice is usually closer to: A) do I buy 100 junk bonds knowing I will catch a certain number of defaults or B) do I buy the 20 best and hope to have better default experience via superior credit analysis?

 

[laurence]

Every person who's told me they can beat the market by "betting on the winners" sounds just like every person who tells me they win in Vegas. I hear the story of the winning black jack hand at least ten times, yet strangly they keep mum the day they are back from a losing trip. Stock pickers always forget their losers.

 

[wabmester]

Unfortunately the world is rarely that simple.  The choice is usually closer to: A) do I buy 100 junk bonds knowing I will catch a certain number of defaults or B) do I buy the 20 best and hope to have better default experience via superior credit analysis?

Superior credit analysis? Not a believer in efficient markets, eh? When it comes to junk bonds, you know it's not Joe Bob whom you need to be superior to, right? It's guys like Buffett and people who do nothing but junk analysis all day every day.

 

[Piffle]

Since you brought up Buffett...

"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."- 1993 Chairman's Letter to Shareholders

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing." also Buffett

 

[ProfHaroldHill]

Since you brought up Buffett...



"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."  also Buffett

Yes, but . . .  compared to Buffett, everybody is ignorant, and nobody knows what he's doing!   

HH

 

[unclemick]

Amen

I no longer have the passion of a 50's teenager to know inner workings of a true hot rod - I just buy transportation (a vehicle ) and use it.

Hence balanced index and a few hobby stocks for dividends.

I understand the pro golf tour is a relatively small number - yet millions get out and try to bang that stupid little white ball.

heh heh heh.

P.S. Buffett also recommended index funds for most investors - don' have the quote handy.

 

[Gone4Good]

Superior credit analysis?   Not a believer in efficient markets, eh?   When it comes to junk bonds, you know it's not Joe Bob whom you need to be superior to, right?   It's guys like Buffett and people who do nothing but junk analysis all day every day.

Couldn't agree more.

I'm a corporate bond research analyst for a major Wall Street firm.  Consider my advantages:

1) I spend 60+ hours / week doing nothing else.
2) I have a staff of people (working even longer hours) building financial models, combing through bond indentures & regulatory filings, and digging up all kinds of obscure data.
3) I have the resources to hire lawyers, consultants or other specialists as needed.
4) I have access to senior management.
5) I talk daily with major money managers (i.e. PIMCO, Fidelity, etc) so I know what they are thinking.
6) Through my sales and trading desks I have an idea what these money managers are actually buying and selling.
7) I specialize in a specific industry sector so all of these resources are brought to bear on a narrow slice of the market.
8 ) I work directly with a market making trading desk so our trades capture the bid / offer spread, rather than paying it

With all these advantages it is still not easy to "beat the market" - largely because everyone else on the Street is in a similar position.  Individual investors are seriously disadvantaged by comparison.

 

[Gone4Good]

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."  also Buffett

Some examples of the Oracle at work help to illustrate why this doesn't apply to individual investors:

In, or around 2002, the energy / power sector was melting down in the wake of the Enron disaster.  The bond markets were closed to the sector and banks were overextended and trying to reduce exposure.  In steps Warren as a lender of last resort.

Williams (WMB) was literally hours away from missing a ~ $400MM principal payment.  On the day of the scheduled payment, WMB announces a new financing arrangement with Berkshire where BRK took an over collateralized senior lien on the company's E&P assets in exchange for a loan accruing interest at ~30%.  BRK was entitled to monthly updates of WMB's liquidity forecasts and if forecast liquidity dipped below a certain level the E&P properties had to be sold.  If the properties were sold, BRK participated in any gains above a certain level.  Afterward, BRK also bought some of WMB's pipeline assets for a song (which incidentally helped WMB's credit quality and liquidity). I'm sure the two transactions were completely unrelated.

Around the same time, CenterPoint (CNP) was struggling with $5 Billion of impending bank debt maturities.  The banks were desperately looking to reduce exposure but the bond market couldn't refinance the entire slug and also was not interested in extending out beyond the term of the remaining bank debt.  Once again, BRK steps in and offers $1.3B of non-prepayable bank debt secured by CNP's utility assets at a generous rate of 9.75% + LIBOR (w/ a 3% LIBOR floor).  The financing allowed the banks to roll and extend.  The reduced liquidity pressure opened up the bond market and everyone lived happily ever after.  BRK's 12.75% loan matures this month.  Similarly secured debt is trading at around LIBOR +40bp.

In BRK's annual letter to shareholders that year, Warren said he found better opportunities in the High Yield market than in equities.  That sent everyone careening into HY at about the time he was moving on to other things.  People reading that letter didn't fully appreciate that the HY opportunities BRK was talking about were never available to them.

 

[greg]

OK, I'll bite. Here's my view on diversification:

On one end of the continuum, we have the single owner of a business who has all her eggs in one basket. He She has complete control over everything related to it and sees changes first. This is where the real money can be made if one is smart, knowledgable, and quick. (Or, manipulative and coercive, like Bill Gates.) This can be very, very risky.

On the other end of the continuum are the the indexers. They know practically nothing about any single business; they rely on whatever they've been told in general and statistical models showing that average growth in this country is about 3%. They try to capure this 3%. Due to this, they tend to focus on reduced costs for their 'big bang' over long periods of time. Not much time is required for this type of investment.

Warren Buffett exists in the middle somewhere, plus he has a staff of highly paid and trained researchers. He can dig up the diamonds/values, study them carefully, expose any flaws or opportunities, and then make investment determinations. He also has unlimited amounts of time to do this, employee man-hours consumed. Most Individuals don't have this luxury unless it's a full-time job.

The real question is how much control you want over your finances.

I don't like either of the first two extremes at this stage of my life. But I'm also well aware that I am not W. Buffet. I can prove that too.

--Greg

 

[greg]

Years to Go: I bought WMB near the bottom, and like a fool sold too soon, anticipating another crash. I also bought Calpine (and lost). Did well on ILD, a preferred stock/bond that I sold too. I was down there in the 'muck of fear' with the best of them. Plus, I'll never forget my Enron debacle.

--Greg

 

[brewer12345]

Superior credit analysis?   Not a believer in efficient markets, eh?   When it comes to junk bonds, you know it's not Joe Bob whom you need to be superior to, right?   It's guys like Buffett and people who do nothing but junk analysis all day every day.

For those who spend their days doing nothing else (like me and Yrs), I would actually say that there is more opportunity and mispricing in the junk market than in the equity market. Part of the reson is structural (lots of rules for regulated entities about owning junk) and part is the nature of junk bond markets (illiquid, big bid-ask spreads, information assymetries, etc.). However, this is probably not a good area for the layman, at least not the real junky junk.

 

[Nords]

Years to Go:  I bought WMB near the bottom, and like a fool sold too soon, anticipating another crash.  I also bought Calpine (and lost).  Did well on ILD, a preferred stock/bond that I sold too.  I was down there in the 'muck of fear' with the best of them.  Plus, I'll never forget my Enron debacle.

--Greg

Considering the Enron precedent I don't think you were foolish to anticipate a further WMB crash.  Although they did have cool cartoons in their ads!

 

[Piffle]

...
Warren Buffett exists in the middle somewhere, plus he has a staff of highly paid and trained researchers.  He can dig up the diamonds/values, study them carefully, expose any flaws or opportunities, and then make investment determinations.  He also has unlimited amounts of time to do this, employee man-hours consumed.   Most Individuals don't have this luxury unless it's a full-time job.

...

I don't like either of the first two extremes at this stage of my life.  But I'm also well aware that I am not W. Buffet.  I can prove that too.

--Greg

There's no need to be Warren Buffett when you can just buy BRK shares.

Hey I'm not 100% in one investment either, but I do like more focus than alot of people here. I have about 20% of my net worth in Fidelity Low Priced Stock in my IRA, 20% in a plain-jane savings type account, and the rest of the 60% is split between BRK and exploiting a particular index derivative characteristic that I have discovered (up 30% on that in the last year, who knows how long that will last).

I just see no reason to have my money in companies that are absolute turds, which is what happens when you are in an index fund. I also happen to agree with many of the analysts that think the next 10+ years in the general market will be relatively flat and that many more non-index funds will outperform index funds over that time frame.

I am also only 33, and saving a pretty big portion of what I make, so I can afford more "risk" than some others here.

Good luck to all in their investments.

 

[haha]

Couldn't agree more.

I'm a corporate bond research analyst for a major Wall Street firm.  Consider my advantages:

1) I spend 60+ hours / week doing nothing else.
2) I have a staff of people (working even longer hours) building financial models, combing through bond indentures & regulatory filings, and digging up all kinds of obscure data.
3) I have the resources to hire lawyers, consultants or other specialists as needed.
4) I have access to senior management.
5) I talk daily with major money managers (i.e. PIMCO, Fidelity, etc) so I know what they are thinking.
6) Through my sales and trading desks I have an idea what these money managers are actually buying and selling.
7) I specialize in a specific industry sector so all of these resources are brought to bear on a narrow slice of the market.
8 ) I work directly with a market making trading desk so our trades capture the bid / offer spread, rather than paying it

With all these advantages it is still not easy to "beat the market" - largely because everyone else on the Street is in a similar position.  Individual investors are seriously disadvantaged by comparison.

So Years, why are you slumming around here?

Ha

 

[Piffle]

There's no need to be Warren Buffett when you can just buy BRK shares. 

I know it is a bit egotistical to quote oneself, but so be it. 

I'd like to make one more plug for a tighter focus of investments.   You don't have to spend tons and tons of time researching investments, you just have to spend some time researching investment MANAGERS.  Why would I spend hours upon hours of time researching stocks when I can hire the best of the best to do it for me?  Do some research and figure out what managers/groups have LONG-TERM track records of beating the indexes.  Study their philosophies of investing and make sure you are comfortable with them.  I don't happen to think that some of these guys with 20-30+ years of success beating averages are just bell curve outliers.  If I spent 40 hours a week studying stocks I could probably beat most of these guys (I've done it), just because of how nimble I can be as an individual investor.  But I'm just not willing to do the time right now.

Here are a few of my favorites, FYI-

Warren Buffett - I think everyone here knows who this is. 

That Tillinghast guy that runs Fidelity Low-Priced Stock Fund - This guy really understands stocks.  I've read a bit about him and I'm impressed enough to have 20% of my bucks under his management.  I kinda lucked out in that this was originally a 401k and I only had 4 fund choices and fell into this one.  Now I'd have to really be spooked to pull it out as the fund is closed to new investment.

The Dodge and Cox guys - These guys are also not only sharp, but pretty conservative, and can still beat the averages.

Ok, that's it from me for now.  I have to go hide from all you Bernstein Fanatics. 

 

[Gone4Good]

So Years, why are you slumming around here?

Ha

Not exactly sure what you mean.

But the quote you referenced refers only to the corporate bond market and to a specific industry within that market.  Furthermore, my employer prohibits me from investing in any way within my sector coverage responsibilities.  So all those "advantages" don't benefit me personally. 

And although I know plenty about money and investing, I knew very little about retirement planning - which is why I'm here.