By Warburton Capital | March 19, 2017 | 0 Comment
Last week a buddy came in speculating that FANG (Facebook, Apple, Netflix and Google) were the only securities any investor should place bets on. According to him, buy FANG and sit back for the next few decades while enjoying market out-performance. Maybe…and maybe not?
Clearly, my buddy isn’t a believer in the Nobel Prize Winning work of Dr. Harry Markowitz who won his prize for proving the benefits of diversification. Dr. Markowitz concluded that “concentrated positions add risk without increasing expected returns.” Given that there are over 24,000 stocks for sale in the 43 highly-regulated security markets around the world, my buddy has, probably unwisely, decided to turn a deaf ear to evidence and bear the risk of concentration.
In our last piece, “The Full-Meal Deal of Diversification,” we described how effective diversification means more than just holding a large number of securities. It also calls for efficient, low-cost exposure to a variety of capital markets from around the globe.
It’s worth repeating – Among your most important financial friends is diversification. What other single action can you take to simultaneously dampen your exposure to the idiosyncratic risk of concentrating in an individual security while potentially – due to the covariant performance of sub-asset classes – improving your overall expected returns? While they may seem almost magical, the benefits of diversification – owning big companies, owning small companies, owning growth companies, owning value companies, owning domestic securities, owning foreign securities and owning all ten sectors – basic materials, consumer cyclicals, consumer durables, energy, financials, etc. – have been well-documented and widely explained by some 60 years of academic inquiry. Diversifications powers are evidence-based and robust.
Having presumed you join with us in embracing diversification, welcome to this the fifth installment in our series of Warburton Capital’s Evidence-Based Investment Insights:
There’s Risk, and Then There’s Risk: Before we even have words to describe it, most of us learn about life’s general risks when we tumble into the coffee table or reach for that pretty cat’s tail. Investment risks aren’t as straightforward. Here, it’s important to know that there are two, broadly different kinds of risks: avoidable concentrated risks and unavoidable market risks.
Avoidable Concentrated Risks: Concentrated risks are the ones that wreak targeted havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident (think ‘oil spill’), causing its stock to plummet. A municipality can default on a bond even when the wider economy is thriving. A natural disaster can strike an industry or region while the rest of the world thrives.
By embracing ‘the science of investing’, concentrated risks are avoidable. Bad luck still happens, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally, as we described in our last post. When you are well diversified, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with plenty of other, unaffected holdings.
Unavoidable Market Risks: If concentrated risks are like bolts of lightning, market risks are encompassing downpours in which everyone gets wet. They are the persistent risks that apply to large swaths of the market. At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (It may be worth less due to inflation, but that’s a different risk, for discussion on a different day.) Invest in the market and, presto, you’re exposed to market risk.
Risks and Expected Rewards: Hearkening back to our past conversations on group intelligence, the market as a whole knows the differences between avoidable and unavoidable investment risks. Heeding this wisdom guides us in how to manage our own investing with a sensible, evidence-based approach.
Managing concentrated risks: If you try to beat the market by chasing particular stocks or sectors, you are exposing yourself to concentrated risks that could be avoided with diversification. As such – and this is proven – you cannot expect to be consistently rewarded with out-sized returns by taking on concentrated risks.
Managing market risks: – Every investor faces market risks that cannot be “diversified away.” Those who stay invested when market risks are on the rise can expect to eventually be compensated for their steely resolve with higher returns. But they also face higher odds that results may deviate from expectations, especially in the near-term. That’s why you want to take on as much, but no more market risk than is personally necessary. Diversification becomes a “dial” for reflecting the right volume of market-risk exposure for your individual goals.
Your Take-Away: Whether talking about concentrated risks or market risks, diversification plays a key role. Diversification is vital for avoiding concentrated risks. In managing market risks, it helps you adjust your desired risk exposure to reflect your own purposes. It also helps minimize the total risk you must accept as you seek to maximize expected returns.
This sets us up well for our next piece, in which we address another powerful benefit of diversification: smoothing out the ride along the way.
Trusting you have avoided the urge to ‘load up’ on FANG and your portfolio is allocated more purposefully, we remain
Warburton Capital Management