Why Diversify?

I tried skeet shooting for the first and only time about 8 years ago.  I missed every moving clay target!

It got to the point where the instructor put the clay targets on the grass so I could shoot them while they were not moving.  Everyone cheered me when I finally hit one (20 minutes later), trying to boost my sunken ego.  The instructor then told me that success in skeet shooting is about aiming at where you think the moving target will be, not where it is currently.

In many respects, long-term investing works the same way.  Markets are anticipatory and asset classes often change direction well in advance of changing fundamentals.  Who would have thought the US stock market would bottom in early 2009, right in the middle of the Great Recession, or that the tech bubble would collapse in early 2000 when earnings growth was so high.  What about the price of gold peaking in late 2011, just as the Federal Reserve was undertaking a massive increase in the money supply?  Did we get a warning in advance of the 1987 market crash?

It is common to focus our investments in asset classes that are doing well at the time.  Admittedly, this can work for a while as momentum in an asset class can last for years.  It gives us confidence that we have a system; a system that not only works now, but whose success can be extrapolated a long time into the future.

The problem is in predicting the pivot points; that is when your asset will shift out of favor.  There are no advance signs that these pivot points will occur.  However, when they do, the shift can be quite abrupt and only realized in retrospect.  These shifts have the potential to wipe out years’ worth of gains in this asset class over very short periods.

We are all very bright individuals, but even the most intelligent market watchers have failed to consistently guess the pivot points (and many a career has been ruined by trying).  Maybe we can guess correctly once, but long-term success will require us to make correct guesses almost every time.  A few wrong guesses and returns accumulated over several years can be easily eliminated.

That is why I believe in diversification.  It is a recognition that none of us know how and when the investment climate will shift (or at least that we can predict this consistently).  It is why it often makes sense to hold on to ugly-looking asset classes whose performance may be a stain on an otherwise pristine portfolio.  It is also why it often makes sense to trim our portfolio’s shining stars even though it kills us to do so.  The asset classes that are subject to the greatest scorn today may be the darlings of the not too distant future.  This will become apparent well after the transition has occurred and there will be no advance signs of when this will happen.

Diversification does not mean low long-term returns.  Aggressive investors can be tilted towards the most aggressive asset classes, while conservative investors will be more focused on the conservative ones.

I would absolutely agree that concentration in one asset class or a group of individual securities has a higher return potential than diversification could ever offer.  However, this same concentration also has the potential of almost complete loss, something none of us could stomach.

I think skeet shooting represents a great analogy as to how markets behave; always anticipatory.  However, we can scientifically measure where the clay target is headed and when it will get there.  Markets offer us no way to consistently predict where they will be in the upcoming years.  Diversification is the most effective tool to spread our risks so that we are ready for almost any outcome.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.