When Diversification Isn’t the Right Strategy

“Wide diversification is only required when investors do not understand what they are doing.”
–Warren Buffett

I got my start in investing in individual stocks back in the late 1990s. I was dating a woman who’d put herself through medical school by working as a nurse at night and on the weekend and by day trading. She would watch CNBC while making her morning coffee, make a few trades, and then go off to her classes. I also don’t think that she ever slept. She figured it would be a good idea to be married to someone with whom she could compete every day. At the end of the day, whoever had made less money got to cook dinner and do the dishes.

As I was preparing to leave the Army to go to law school, this sounded like a great idea to me. I had a classmate from West Point who was rumored to have turned his $15,000 cow loan (a 1.5% interest rate loan that we received in our junior years, nominally to buy a car) into $250,000, which he was using to pay cash for a top tier business school.

I invested my first $1,000 in Skechers. When it didn’t do what I wanted, I invested in a penny stock. That stock went bankrupt. My $1,000 turned, slowly, into $0. You can read the full story in my article “Get Rich (Somewhat) Quick.”

Through a stroke of luck, when I’d joined USAA at West Point, someone in their organization told me about mutual funds. I was 18 and had no idea about investments, and the woman that I spoke to quickly explained the benefits of mutual funds. A mutual fund allows you to invest in a basket of investments (usually stocks and/or bonds) that you could not otherwise invest in. I picked four, invested a little each month in them, and forgot all about it.

Thus, when I lit $1,000 on fire invested my first effort at individual stocks, my net worth wasn’t sunk because I had those USAA funds that I’d been investing in all along. That’s not to say that I was financially bulletproof, but losing $1,000 hurt psychically more than it did fiscally.

So, when people ask me about what to invest in or how to invest, I’m generally going to tell them to invest in mutual funds to diversify away the risk. One bad investment is balanced out by hundreds of other investments, and all of them will have to go bad at the same time for you to get tragically hurt.

The problem is that the opposite also holds true. If you want to shoot for the moon, you’ll never get there by investing in mutual funds. There will be no one year six bagger on a mutual fund, just as you’ll almost certainly not go broke in a year investing in a mutual fund.

Why recommend that people invest in mutual funds then? The simplest answer is that nobody on the planet knows enough about enough specific stocks to be able to read the tea leaves of the future and repeatedly pick surefire winners. Someone who picks one stock that wins is statistically much more likely to be lucky than skillful, and the ability to repeatedly pick the winners over time is almost assuredly not there. In other words, the roulette wheel might have landed on 00 when that person bet 00, but it won’t land on 00 any more than the other numbers, and the house will win over time.

There are exceptions to the rule, though.

Let’s look at one example.

I recently was on a long weekend in Austin, Texas. Since my wife had waited on me basically hand and foot for a week while I was recovering from complications from knee surgery, to repay her, I’d bought her a spa day. She was getting pampered, so I went a local café to grab an early lunch and a coffee. I sat outside, and there was a woman at the table next to me drinking coffee. She had her dog with her. I am a sucker for dogs, so I went over to say hi to the dog. We started chatting and wound up talking the entire time that my wife was receiving the Milky Way treatment (it was out of this world, according to her).

The woman was a property manager and had quite a number of properties under management. She also was a real estate broker, although she didn’t do many deals – mainly for the owners of the properties she managed. She had been managing properties for a couple of decades, and had grown her company nicely over time. She also never had enough properties; even in down economic times, she had more potential eligible renters than she had houses to put them into.

I waited for an opportunity in the discussion to ask her why she wasn’t buying properties and putting those qualified potential renters – the ones that she was having to turn down and foregoing revenue for – into her own rental properties.

“That’s what I should have done,” she rued. She had received a significant inheritance from her parents. Instead of using that money to buy rental properties, she had gone to a strip mall financial planning firm that then proceeded to follow the Holy Trinity of investment failures. First, her “investment adviser” put her into front loaded mutual funds. Then, he charged her an assets under management fee. Then, the market tanked, so he tried to make up for the losses by actively trading stocks for her. The rest, for this woman, was a sad history in a story I wish I was making up. Instead of having enough money to buy several investment properties, she now had enough to only buy one or two.

Even though I’ll take any chance to tell you what a bad idea sending your money to a strip mall “investment adviser” is, the purpose of that tale isn’t to rail on her “adviser.” It is, instead, to point out a situation where diversification of investments was a bad idea.

Here is a person who knows rental real estate back and forth. She had decades in the industry. She was a broker. She had access to the best deals, either from her own shadow listings of property owners who were looking to cash out or who were tired of being real estate owners, or through the shadow listings of other agents. She had access to cash to purchase the properties, and she had immediate access to people who would pay to live in those properties. She had her own staff of handymen to fix up properties that needed fixing up.

In other words, she had the ultimate opportunity to value assets, identify the underpriced assets, and then profit from her knowledge. Real estate is, as it is currently marketed and sold, an industry where there is both imperfect information and a set of irrational players, and this woman was positioned in the middle of it and could have taken every advantage of her position to create a rock solid portfolio of investment properties.

Instead, she “diversified” because that’s what the “investment adviser” told her to do.

Let me reiterate a point here before I continue.

You invest in mutual funds and diversify your investments because you’re in a situation where you do not possess a superior informational advantage nor the ability to control the outcomes of your investments. For most of us, that’s a straightforward, common sense, and very appropriate strategy.

I put the last phrase in bold for a reason. If you invest in XYZ stock, then the most influence that you can have in the outcomes of XYZ is to vote and participate in a corporate board meeting. You may, if you’re extremely lucky, have the opportunity to speak and hope that your rhetorical skills are sufficient enough to get the opportunity to further influence how the company is run, but the reality is that the percentage of ownership that you have in a company is microscopic and your proxy votes don’t affect the outcomes one iota.

In other words, you’re along for the ride. If you buy a mutual fund, then the fund will vote your proxy shares for you. Again, you’re along for the ride, but you’re placing hundreds of exceptionally small bets. In either case, you don’t control the outcomes of your investments. Since you have no informational advantage over anyone else for those companies, that’s perfectly fine. They can run the companies, and ideally, more of them do well than don’t. You get to spend your time on more important things, like your family, your hobbies, and the other activities which are truly important to you and give you meaning in your life. It’s a reasonable trade.

There are a few outliers, though, where this approach does not make sense. Let’s look at some of these.

• You’re in the middle between buyers and sellers. In the story I related above, the woman I spoke with knew the sellers of properties, both sellers of rental properties as well as sellers of other properties which were undervalued and could become rental properties, and with the buyers of rental property services, namely the potential renters that her property management company was having to turn away, even in bad economic times. She knew the demand and could provide the supply. It would be hard to find a better investment situation.
  That’s not to say that I don’t know Realtors who have gone broke taking that logic to an unwarranted conclusion. They normally fall for the Dunning-Kruger effect, meaning they believe that they’re better at something than they really are. They sell a couple of homes, their Monkey Brains see visions of mansions and enormous bank accounts and a reality show gig on HGTV and they leverage themselves to the hilt to buy properties with the intent of flipping them. When the flips flop, they go bankrupt.
  There’s a fine line between intelligent investing and sheer gambling, and Monkey Brain lives on the other side of that line.
• You run a small business where you can’t service all of the demand. If you have a small business that is profitable even after it pays you a reasonable salary, and you are having to turn away customers, then there’s an opportunity to reinvest in the growth of your own company. Naturally, you have to be able to grow while still providing your customers with the same (or better) level of service in order for this strategy to work, but where else will you have more control over your own outcomes than in the business you run?
• You can invest in yourself to earn a higher salary. I can think of many professions and jobs where you can earn a higher salary if you get an advanced degree. Teachers and government workers are two which come to mind. Usually, police forces offer higher pay for advanced education as well. Those are almost guaranteed returns on investment assuming that there is no downsizing. In corporate jobs, it will be a risk-reward tradeoff, where you will need to weigh the true probabilities of getting a promotion or a pay raise compared to the costs – both monetary and time-wise, since you’ll probably have to go to school on nights and weekends – of getting that education.

There are no guarantees in investing, regardless of what you invest in. Stocks can go down. Housing markets tank. Customers can disappear.

That doesn’t mean that you should always make your money bow down prostrate at the altar of diversification. Most of the time, this is the best investing strategy, and it’s probably the safest bet out there for many of you who are reading this article. For some, though, it’s the unwise choice. When looking at your investment choices, don’t scoff at the notion of investing in yourself and in an investment that you truly know and can control. If you can control your own destiny, don’t diversify away that control simply because that’s what the gurus tell you that you should do.

How would you feel about doubling down on yourself? Let’s talk about it in the comments below.