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Diversification

Diversification: Winning the War by Losing Battles

Diversification involves knowingly accepting some individual losses in order to gain long-term returns.

Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: May 11, 2018

Diversification is a way of coping with the fact that we don’t precisely know which asset classes will perform best month-to-month or year-to-year.

Strangely, a well diversified portfolio can feel like you’re always under-performing as it will never be the best performing asset class in the short-term.

Being diversified is a way to win at growing your overall wealth, even though you don’t win every year

As a youngster, I once read a book about wandering tribes who would settle disputes by one-on-one combat with champions representing each tribe. If you had the strongest set of warriors, you won. But that wasn’t always true.

In the novel, one tribe—let’s call them the Nerds—was challenged by another tribe, who we’ll call the Bullies, and the Bullies were clearly stronger when compared person to person.

There was always at least one warrior from Bullies who could beat a warrior from the Nerds.

Nerds vs. Bullies:
Skill Level Ranked 1 (Best) through 10 (Worst)

Bullies Nerds
1st Champion 1 2
2nd Champion 3 4
3rd Champion 5 6
4th Champion 7 8
4th Champion 9 10

There’s no way the nerds could beat the bullies, right? Still, the Nerds challenged the Bullies. They said, “Show us your most powerful warrior, and we’ll defeat him.”

So, the Bullies sent their strongest champion into the ring first… and the Nerds sent their weakest. With little effort the best of the Bullies beat the weakest Nerd.

But what the Bullies didn’t notice was how that one loss completely changed the line-up. Look at what happened in the chart below.

Nerds vs. Bullies: Lineup after One Loss

Bullies Nerds
1st Champion 1 (won) 10 (lost)
2nd Champion 3 2
3rd Champion 5 4
4th Champion 7 6
5th Champion 9 8

After taking the loss, the Nerds were well set up to win the other four contests. They intentionally lost a battle in order to win the overall competition. That’s the value of having an overall strategy.

A similar phenomenon happens when you use a diversified investment strategy. Because nobody can predict what kind of investment (i.e. asset class) will be a “winner” at any specific time, diversification aims to make sure you win out in the long-term by taking a few losses along the way. This is exactly why a large portion of our portfolio strategy construction focuses on diversification.

It’s natural to want to win. Good investing strategy is about being okay with losing when you can afford to.

Investing is often most stressful when you’re trying to win all the time. And that’s usually when we’re least effective as investors too.

The modern world will tell you all about the lucky people who won it all, leading you to believe a perfect track record is the norm. But people don’t often discuss the strategy required to actually get the wins.

Take Warren Buffett, who is widely considered to be one of the most successful investors in the world.

  • Through the start of 2016, his company, Berkshire Hathaway, had a -14% return while the S&P 500 was down only -4%.
  • From 2004 to 2005, Berkshire Hathaway returned about -13% The S&P 500 was up around 10% in the same period.
  • From 1998 to 2000, Berkshire Hathaway had a -48% return. The S&P 500 was up 23%. That’s a -67% underperformance.

See this article from “Flirting with Models” by Newfound Research, for all of the data on Berkshire Hathaway and the S&P 500.

Would you have stuck with Buffett through his losing years?

It’s easy to be a “hindsight expert,” who tell you how you should have invested. Real stories certainly makes us feel like we can trust those who tell them, but … when we are contemplating the future, we can’t rely on repetition.

A winning investment strategy rests on both principles and data. And sometimes the data will include losses, and it’s how you manage yourself and your investments through those losses that matters.

When you are looking to get comfortable committing to a strategy, you usually want to see it ‘win’ a first few battles. Following a strategy that by definition will never be the best performing over any period of time can seem crazy. That is, until you realize that it will likewise never be the worst, and that the rewards for never being the worse far outweigh the rewards from being the best. If you experience a 10% loss, it take a 12% gain to get back to even. If you experience a -100% loss, it’s impossible to recover.

Winning by allocating to ‘losers’

Let’s look at how a simple strategy of investing 100% of your wealth into whatever performed best last month. For this, I’ll break the US stock market into sectors, and show the performance of each sector.

In the graph below, the light grey lines show the performance of individual sectors like Consumer Staples and Telecomms. The blue line represents a portfolio that invests equally into each sector, no matter what. The orange line depicts a portfolio which invests in whichever sector performed best last month.

As you can see, the equally weighted portfolio is NEVER best in any given month– it’s the average of all sector returns, after all! But over many months, because it never has the worst downs, it does come out pretty well.

Comparative Growth of $1

growth of a dollar diversified portfolio

The portfolios and sectors above are total returns net of fund fees.
Data: Xignite, Analysis: Betterment. Sectors represented by Vanguard sector funds.

The graph below shows how each asset class performed relative to each other over the past 15 years, and our diversified 70% stock tax-advantaged portfolio. As you can see, the diversified portfolio is always in the middle of the pack. It’s never the worst, and never the best performing.

Diversification Exemplified by a Betterment Portfolio

All total returns net of fund fees. Data: Xignite, Analysis: Betterment.

In fact, it’s easy to pick a future loser by choosing current winners. If you picked an asset class that was above the diversified portfolio this year, the odds that it would also be a winner next year is just about 25%. That’s worse than choosing at random!

Be a strategic general with your money

It can be very tempting to decide what to do with your money based upon a very very small number of “battles”. But as the overall manager, it’s your responsibility to keep the big picture in mind, and accept some losses in exchange for an overall win. This is about being properly diversified.

How diversification works is one of the toughest lessons to learn in investing. Diversification is protection against an unknown future: we need to hedge our bets about being wrong by being wrong in many small ways rather than one large way.

As a consequence, diversification means you know you will hold some underperforming asset classes, just not which ones. In compensation for small losses, you know you’ll never have huge ones.

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