Diversification is Your Friend

Tuesday, August 6, 2013 5,653 views

Mark Hebner: Welcome back to IFA.tv. I'm Mark Hebner, President of Index Fund Advisors, and this is our second part in our three-part series with Weston Wellington. Weston's a Vice President over at Dimensional and part of their in-house research team, and known worldwide as being one of the foremost educators on how capital markets work. In Part Two, Weston's going to discuss the all-important idea that diversification is your buddy. It's a famous quote from Nobel Laureate Merton Miller, and here's Weston to further expand on this important topic.

Weston Wellington: In this session we're going to discuss the topic of ‘diversification.' One leading economist number of years ago said, "diversification is the investor's best friend."

Another leading researcher said, "diversification is the closest thing to a free lunch in all of finance. You want to eat a lot of it."

To continue with that food analogy a bit, diversification is a lot like eating your vegetables. We all know it's probably a good thing for us in the long run, but from time to time that six pack of beer, the doughnuts, the potato chips – they seem a lot more appealing.    

Diversification* means don't put all your eggs in one basket, something most of us have heard since we were children. Then again we probably all nod our heads and say, "that's a great idea."

*Diversification does not eliminate the risk of market loss.

But when it comes to the opportunities available to us in the securities markets, let's acknowledge that the temptation to concentrate, to put most of our money in one terrific idea can be very powerful and seductive...because sometimes it does work or at least it seems to work.

As an example, you could have bought shares in the Initial Public Offering back in 1986 of a company that turned out to be one of the world's leading software companies. How much money could you have made if you purchased those shares at the first opportunity? Roughly speaking, about 800 times your money. That's a pretty strong incentive to try and find the next big thing.

But if we're a student of history in this country or around the world, we soon learn that change is ‘baked in the cake,' almost everywhere we look.

Companies that at one time were huge prosperous enterprises…decades go by and they shrivelled and maybe even disappeared.  As an example, all of the companies pictured* here were at one time leaders – often pioneers – in their respective industries.

*Pan Am, Bethlehem Steel, Kodak, Polaroid, GM, Washington Mutual, Bear Stearns, Delta, K-Mart, Wang, Circuit City, Waterford Crystal, Hartmarx, A&P

Pan Am in aviation, Bethlehem Steel introduced the steel I-Beam and revolutionized the construction industry, Polaroid invented instant photography...on and on...A&P introduced the notion of self-service super markets.

What's the other common thread among all these companies? They've all gone bankrupt! Every one.

Now some of the companies are still here like General Motors, but the original cohort of equity owners were wiped out. They lost every penny. What's the point? The point is we can never know with certainty whether the company we own shares in today is going to continue to thrive and prosper – or could it turn out to be another Eastman Kodak or Bethlehem Steel that had some glorious years, was often held up for admiration but is now just a footnote in financial history?

Perhaps an even more striking example, relatively recent...in December 2001, a prominent financial magazine had a cover story about what they described as America's safest stock – the closest thing they said to an invincible earnings machine – had come through the recent recession without a scratch.

What do you suppose America's safest stock was in 2001? As it turned out, it was Fannie Mae. When it was supposedly the safest stock in America, the shares sold for over $79 a piece.*  More recently worth 26 cents.**

*year end 2001  **year end 2012

If this isn't an argument for diversification, perhaps I'm out of bullets.

Let's look at it from a little different perspective. Rather than try to predict what might happen in the future, let's look at the past – the recent past. How easy is it for us to recognize which have been the best performers, let alone try to predict those in the future?

We take these two constituents of the Dow Jones Industrial Average – the world's largest cola firm and the world's largest restaurant chain. Which one as it turned out was the more rewarding investment for the past 15 years? If we'd been at the starting line so to speak back in 1998, was it obvious which of these two companies would be the more profitable investment? What happened to a $10,000 investment in each of these two companies? Both of them were profitable, but one more than quadrupled in value, while the other was up about 35%.

Two other constituents of the Dow Jones Industrial Average – a leading construction equipment maker and one of the world's largest chemical producers...again 15 years ago, we had to look ahead and imagine which one of these two would be the superior performer.

It turned out to be the heavy construction manufacturer, not the chemical firm.

What about the computer technology industry? We take two more constituents of the Dow Jones Industrial Average and ask ourselves, "could we have known 15 years ago which one would turn out to be a more rewarding investment?" In this case, one more than quadrupled in value; the other actually lost money. A striking example of the power of diversification and the danger of putting all of our eggs in one basket.

Shifting gears a little bit, let's do a little time travel back to 1983. You're reading the newspaper at the breakfast table, and you come across this article. This gentleman here who is an engineer at a leading technology and communications firm, and he's helped to perfect the world's first practical mobile telephone. Now you know this thing kind of looks a little clunky, expensive – and it was expensive – four thousand dollars back in 1983.

Well, you're about to turn the page. This looks like an overgrown science experiment that's probably doomed to fail, but your fairy godmother pops up and she says, "don't turn that page. As your fairy godmother, I can see the future, and I can assure you these things are going to get smaller and cheaper, smaller and cheaper. They're going to sell by the millions, tens of millions all around the world. And I can further guarantee you that this particular technology firm is going to be a leading participant in this very exciting, vibrant new industry."

Poof, she's gone! Wow, thanks fairy godmother, what a great tip. I'm going to call my broker right now and buy some shares. Now your godmother has allowed you to share this idea with only one other individual...who do you think...your brother-in-law!

He's a hard working guy, he works out of Minnesota for this meat-packing company. They put pork shoulder in tin cans all day long, and he listens politely to this idea from your fairy godmother, but he says, "no I'm going to keep investing in the shares of this meat packing company that I work for...but thanks!"

Well, what a knucklehead. This is a guarantee from your fairy godmother. This is the wave of the future. Meat packing is yesterday's kind of industry. What happens over the next 25 years? What's their respective investment return of these two very different companies – a leading edge technology firm and a traditional meat packing company? Well, the shares in the technology firm returned 448% for that 25-year period, but our meat packing firm returned over 2,000%.

This is not an argument saying you should avoid technology stocks. This is not an argument saying you should own shares of whatever's in your cupboard or your icebox.

This is an argument for diversification. We don't know where lightning may strike next. Sometimes some of the most attractive returns may be associated with some of the world's dullest sounding companies.

One leading economist described investing in the stock market is like a gambling casino with the odds in your favor. There's a lot of truth to that observation. Every one of us as investors essentially has a choice. We can conduct ourselves and behave like the gambler pictured here…go to the casino, and maybe if we're lucky, strike it rich and go home with bags full of money. But I think most of us acknowledge that the gambler who goes back to that casino over and over and over again is going to win some, is going to lose some, and over time, what is our expectation? The mathematical expectation is: you're going to lose money as a gambler. The odds favor the house.

Now fortunately for investors you get to choose. You don't have to be a gambler. You can own the casino. You can be the casino. Yes, you may lose on any given day or weekend when some gambler hits a hot streak, walks away with some of your money. The longer they play, the more the odds favor you…and we look at a photograph of Las Vegas and the strip and see all those glittering billions, billions of dollars worth of buildings. Where do those billions come from? From the pockets of the gamblers! So as investors we want to be the casino owners, not the casino customers.

Thank you very much.

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