April 20, 2009
After the huge losses in markets last year, the long knives have come out on diversification.
It seems that everyone now shuns the idea of owning multiple asset classes. Curiously, no one was complaining in 2002-2007, when bull markets prevailed in just about everything. Of course, the crowd has a habit of promoting (or remaining quiet when it comes to critical comments) about strategies that are working in real time. After the fact, it's all a bunch of hogwash. So be it. That's the nature of finance: History, and what passes for intelligent counsel, is constantly being rewritten to suit the moment.
The latest attack comes from Jim Rogers, celebrated trader and promoter-in-chief of commodities as the solution to what ails investors everywhere. For the record, we like and respect Jim Rogers. He's earned a well-deserved reputation as a trader who's made a fortune in a business where success is rare. His record speaks for itself. But we disagree vehemently with his latest commentary on diversification, which he equates with a cheap trick dreamed up by brokers trying to fleece clients. Here's what he said, verbatim, courtesy of an interview last week with BusinessWeek:
Diversification is something that stock brokers came up with to protect themselves, so they wouldn't get sued [for making bad investment choices for clients]. Henry Ford never diversified, Bill Gates didn't diversify. The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket. You can go broke diversifying. Ask anyone who's diversified in the last three years. They've lost money.
With all due respect, Jim, you're not being fair to diversification, nor does it appear that you fully understand what it is, what it's designed to do, or not do, and what's required of investors who manage a "diversified" portfolio. We'll be diving into these questions and the related lessons in more detail in the next issue of The Beta Investment Report, but here are a few thoughts as a preview.
First, let's define diversification, which can mean different things to different investors. The standard definition relates to diversification within an asset class—owning a broad equity index fund, for instance, vs. one stock. That by itself doesn't mean an investment portfolio's diversified. That higher standard requires owning multiple asset classes, with an emphasis on those that tend to move with some degree of independence. The classic example is a portfolio comprised of stocks and bonds, although there are many more combinations available in the 21st century.
On that note, diversification with stocks and bonds performed quite well last year relative to owning stocks alone. Although equities were crushed last year, a broadly defined fixed-income fund did quite well. One example is the iShares Barclay Aggregate ETF, which posted a 7.9% total return in 2008.
Meanwhile, the asset class that Jim Rogers loves so much—commodities—suffered one of its biggest losses last year, to which we're reminded of the proverb in Luke: Physician, heal thyself. Jim has been promoting commodities in recent years, and for quite a while it was a great call. But not last year. Perhaps owning something more than commodities wasn't misguided after all.
Ultimately, asset classes are neither good nor bad, although their expected returns and risk vary through time. The key lesson: the price of risk means something, all the more so because it keeps changing. That implies that we should pay attention and adjust asset allocation accordingly. In a perfect world, with absolute foresight, we wouldn't need diversification or asset allocation. We'd simply pick the best investment destined to dispense the highest return.
Unfortunately, it doesn't work that way. Sometimes even the smartest investors make mistakes, reminding that we're all fallible. With limited insight into the future, prudent investors will hedge the risk. The breadth and depth of the hedging will vary depending on the individual or institution. Some of us are more risk averse than others.
Meanwhile, some of us are more confident than others about what's coming. Jim Rogers, for instance, is still bullish on commodities, as he explains in the interview noted above. (As a digression: Was he bearish on commodities a year ago?) In any case, let's say you agree that commodities look like a great play on the future. Let's say too that you're wildly bullish on commodities. Are you going to put your entire portfolio into commodities? Or how about putting everything into agricultural commodities? Rogers is apparently quite bullish on the likes of corn, wheat, etc.
We'd recommend otherwise, even if you're the world's smartest commodities bull. Yes, you might want to overweight commodities, perhaps aggressively, relative to the passive weight implied by Mr. Market. But shunning diversification entirely? It's hard to think of a more dangerous piece of advice, especially for the masses. Then again, your editor isn't a highly regarded trader and so maybe we're just uninformed.
Posted by jp at April 20, 2009 9:44 AM
Do not trust the big egos that can't think beyond their own noses. The man is less than thoughtful.
It is utterly irresponsible for Mr. Rogers to advocate putting all your eggs in one basket. He and Buffett can afford 50% drawdowns. Joe public can't! They are by definition speculators: they forecast. If they were to live long enough (say a few hundred business cycles) they will wipe out.
I am afraid that this will never end.
Diversification is always going to cause more pain when there are liquidity issues and correlations converge! There is nothing new here! Nothing to be surprised about. Diversification is poorly understood. It is not about safety! It is about having more opportunities in a given period which provides for greater growth.
That does not change that proper diversification is seldom practiced. Every investor should own "the market": every investable asset on the planet. That is proper diversification.
Safety is achieved elsewhere. It has to do with the dispersion of outcomes.
Posted by: Mr. Kristian L. T. Blom at April 23, 2009 1:55 AM
I agree that we can and should make a distinction between smart diversfication and diversification that's not so smart. I also agree that the expected returns vary through time, as does the price of risk, and these fluctuations are partially predictable--maybe--and so that suggests that asset allocation should be managed dynamically, at least partially so. My newsletter, The Beta Investment Report, is dedicated to that proposition. So too is a book I'm finishing up on the subject. In short, it sounds like we are in agreement. Rogers, however, seemed to be dismissing diversification completely, or so his comments suggest, and on that point I disagree.
Posted by: JP at April 21, 2009 7:28 PM
I think you are mislabeling what Jim Rogers is trying to say. I have seen hundreds of portfolios "managed" by investment advisors and stock brokers over the years and to compare a globally diversified portfolio of index funds with what most "advisors" do is comparing apples to oranges.
Rogers is advocating what has worked for him, but most people don't have his intestinal fortitude. I think what Rogers is saying is that holding assets priced to perform poorly or mediocre only to "diversify" is stupid - Buffet would agree I think. For example, owning US large cap stocks since they became over valued on a long term basis since 1998 has been a poor allocation of capital. This IS PREDICTABLE IN ADVANCE! The problem is most people have neither the patience or stomach to sit out periods of speculative gains.
You try to characterize Rogers as being somehow wrong about commodities because of last year. His commodity call is one for a 20 year time horizon, and his index is up over 120% since he made his call for commodities in the late 1990's - compared to a -20% decline in the SPX.
Personally, my business is designed to try and balance what Rogers'/Buffet preach and the reality of dealing with human beings as clients. Volatility is important to manage due to individuals inability to stomach it in too large of doses, so therefore we diversify. However, we diversify via brain power/strategy rather than holding overvalued asset classes.
So you can stick with your apparent advocacy of owning overvalued assets classes and sentence people to poor to mediocre long term returns in the name of reducing short term volatility (hopefully). I'd prefer to take risks where they are most likely to be rewarded over a reasonable investment time horizon and try to manage the cyclical volatility inherent in every market.
Posted by: James Dailey at April 21, 2009 1:16 PM
I guess if I was Warren Buffett, and had his talents for stock picking, I too could dismiss diversification. Then again, Buffett is on record as recommending index funds, the epitome of diversification. I quote from Berkshire Hathaway's 1993 annual report, in which Warren writes:
"By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."
Mr. Buffett repeated the advice ten years later, in the 2003 letter to shareholders, advising that "those index funds that are very low-cost…are investor-friendly by definition and are the best selection for most of those who wish to own equities."
Posted by: JP at April 21, 2009 8:32 AM
you have every right to disagree with what Jim Rogers said on the subject of diversification but it's ridiculous to say......"nor does it appear that you fully understand what it is, what it's designed to do "..
come on at least be realistic.
If I remember correctly Warren Buffett broadly agrees with Jim , did he or Charlie Munger not call it " diworseification "
Posted by: VineL at April 21, 2009 3:56 AM
you said in the article that you couldn't think of a more dangerous piece of advice than not diversifying.
I think i can think of something more dangerous.
Leveraging up too much.
Posted by: yo at April 20, 2009 3:45 PM