Why Diversification Fails In Uncertain Markets
Why do investors diversify their portfolios? Because that’s what everyone is telling them to do. People diversify their stock portfolios but why? All the talking heads, so-called experts, and economists tout diversification for minimizing risk, but do you know what else it minimizes? Returns.
Here’s the kicker: While diversification minimizes risk, this is only true during good times. In bad times, diversification won’t save you. If the stock market crashes, mutual funds and every other diversification strategy that 401(k) and IRA owners rely on for their retirements fail.
In 2008 when the market shed 50%, potential retirees saw their 401(k) ‘s shrink as well because diversification doesn’t save you in a crash. The running joke was that the Financial Crisis was turning 401(k)s into 201(k)s. The nation’s 401(k)s and IRAs lost about $2.4 trillion in the final two quarters of 2008. In 2008, those aged 30-50 saw average returns of -30%; over half of those over age 60 lost more than 20%.
Mutual funds are touted for reducing risk but are also the poster children for underperforming. For example, 92.43% of large-cap funds fail to beat the S&P 500.
To summarize, diversification minimizes returns during good times and offers no protection during bad times. So why diversify? It’s no wonder billionaires like Mark Cuban and Warren Buffett are against it.
“Diversification Is for Idiots.” -Mark Cuban.
“Diversification is a protection against ignorance . . . makes very little sense for those who know what they’re doing.” -Warren Buffett.
The problem with diversification is while it may dilute risk, it also dilutes returns. Smart investors typically concentrate on one or two industries with a long track record of success and stick with those.
Why dilute top-performing asset classes with ones that are more unpredictable or volatile?
The problem with diversification is investors have tunnel vision and are only thinking within the Wall Street sandbox. If they looked outside of Wall Street and focused on alternative private investments, they would think of diversification from a different perspective.
Diversification That Does Work
There is a way to make diversification work for your portfolio, but you won’t find it in the stock market. You’ll find it in the private markets. In the private markets, there is a way to diversify without diluting your returns while sticking to just one or more industries.
How? Through inter-asset diversification. Inter-asset diversification is smart diversification. It’s concentrating on one industry but diversifying through other factors, as described below. By concentrating on one industry or asset class, it’s possible to mitigate risk without sacrificing returns. And the asset class, most ultra-wealthy investors gravitate towards commercial real estate (CRE) for this type of diversification, which offers multiple dimensions of attributes that make diversification work in their favor.
What sets CRE apart from common stock is it offers more than growth for the returns it generates for investors. CRE generates appreciation AND income. Because of the income component, which is ideal for compounding wealth exponentially through reinvestment, savvy investors leverage diversification to protect cash flow and not to reduce risk. Protecting cash flow allows investors to diversify while maintaining returns.
Smart investors stick to one asset class but diversify across multiple segments within that asset class or across multiple assets within a particular segment. Smart investors have long been heavily allocated to CRE for its consistent and reliable income and appreciation track record. There is an additional reason for sticking to CRE. When an investor focuses on one asset class like CRE, they become knowledgeable and skilled in analyzing deals in that asset class, which allows them to let go of the reins and invest passively to leverage the skill and experience of others.
Investing passively allows sophisticated investors to practice true diversification by investing across multiple geographic locations with varying exit strategies, compensation structures, and terms. By sticking to one asset class like CRE, investors are more able to confidently and competently screen passive opportunities because they know how to analyze deals.
There’s a way to make diversification work for you, but it doesn’t involve Wall Street. It involves private alternatives.
By focusing on performing alternative asset classes like CRE that are uncorrelated to Wall Street and unbound by its rules, investors can diversify to mitigate risk without sacrificing returns. It’s the only type of diversification that makes sense for the smart investor.
Michael Foley, president and CEO of Humabilt Capital, oversees the entitlement process, funding, and operations for Humabuilt Capital. Mr. Foley has been a full-time real estate investor since 1995 during which time he has developed hundreds of single-family homes, townhomes, condominiums, and apartments. Mr. Foley started his investment ventures in Long Beach, California, and has expanded to Apex and Durham North Carolina. Mr. Foley is a graduate of the University of California at San Diego.