Diversification vs. Concentration

June 21, 2017

Diversification vs. Concentration

  • Index funds and diversification have worked extremely well in the past 35 years, however their success can be thanked to geography, as we hear only about the success in the U.S., and to declining interest rates.
  • If the S&P 500 had the same earnings yield as when the Vanguard fund gained traction, it would be at 557 points, yes 77% below current levels.
  • It’s better to wait in cash than buy a diversified index fund now.

Introduction

Some investment gurus advocate spreading your portfolio across various asset classes in order to limit your risks for the same return. On the other hand, others say diversification is for idiots and for those who don’t know what they’re doing. I’ll analyze their arguments and see what the best option is for you.

Diversification

The strongest advocates of diversification are passive investment funds with Jack Bogle, the founder of Vanguard, at their helm. His quote explains the rationale:

“Don’t look for the needle in the haystack. Just buy the haystack!”

As over time, Vanguard and similar funds have done pretty well, we could assume that buying everything is the smart thing to do. However, consider this, Vanguard was founded in 1975 and its first index mutual fund was launched in 1976 while total assets under management for the whole group didn’t reach $1 billion until 1980, exactly one year before the largest bull market in history began.


Figure 1: Vanguard’s history. Source: Vanguard.

Another tailwind has been declining interest rates. As interest affects asset values like gravity, declining interest rates work like a rising tide, and thus lift all boats.


Figure 2: Since 1980, the federal funds rate has only been going down. Source: FRED.

One of the main reasons index funds have performed so well is the monetary environment. I’m not familiar with any investor who was extremely diversified before the 1980s and became an investing legend while there are many concentrated investors that have significantly outperformed the market both before and after 1982.

Another tailwind for Bogle is the fact that his fund operated in America and invested in the S&P 500. Those who invested with a similar attitude in other indexes—for example, the Nikkei—have largely underperformed.


Figure 3: Nikkei vs. S&P 500 since 1985. Source: Yahoo Finance.

However, I must say there are some benefits to index investing. The first is the extremely low cost Vanguard funds have. On average, their mutual funds have an expense ratio of 0.12%. The second advantage is the peace of mind they provide the investor.

Since the 1980s, index funds have performed very well, but is it morally right to promote such investment vehicles now that interest rates are at their historical lows and at an inflection point?

By looking at valuations (I’ll use the cyclically adjusted price earnings ratio (CAPE) to smooth out cyclical influences), stocks are 4 times more expensive than they were in 1981.


Figure 4: S&P 500 CAPE ratio since 1981. Source: Multpl.

The CAPE ratio was 6.64 in June 1982 and now it’s 29.81. Thus, index investors in 1982 had an expected earnings yield of 15.06% while current investors have an expected earnings yield of 3.35%, which is a huge difference.

When the S&P 500 returns to a level where the CAPE ratio is below 7, you can expect an article from me that will tell you that the S&P 500 is finally a great investment. Be aware that at current earnings, the S&P 500 would then be at 572 points, thus 77% below current levels.

Until then, I prefer concentration and temporal diversification.

Concentration

One that praises index funds but is very concentrated is Warren Buffett who said:

“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is [going to] be a terrible mistake. Very few people have gotten rich on their seventh best idea.”

Charlie Munger, Buffett’s partner, is known for not being so gentle with his words, so he compares diversification with insanity:

“The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn’t make you with a whip and a gun?”

Now, there are also some cons to concentration. You have to know how to analyze and compare investment opportunities, you also have to research and then you have to tolerate higher levels of short term volatility. Is it worth it?

Well, if you jump on the bandwagon with everybody else, your returns will be around 3% to 4% for the next 20 years amidst two severe bear markets. However, if you invest in 6 great businesses over the next 6 years, you can easily achieve returns of above 10% per year, probably with less risk because you would own great businesses bought at a lower than market average valuation.

The difference? Well, a million dollars compounded at 4% over 20 years ends up at $2,191,123, while the same million compounded at 10% per year ends up at $6,727,499. So a bit of research and investment knowledge can give you three times more than what index funds can do. In this way, you can enjoy a nicer home, better retirement, a better college for your kids, or whatever your wish is. If you can imagine what to do with three times the money in 20 years, then index investing is definitely not for you.

When interest rates rise, investment returns above 15% per year shouldn’t be excluded, so the difference could be even greater.

Where can you find investments that yield more than 10%? You have to look where others don’t like to look because they don’t understand what’s going on. For now, think Brazil, China, pharmaceuticals, fertilizers, metal miners, etc., but there are also S&P 500 companies that have a P/E ratio of 15 and nice long term growth prospects that will definitely lead to average 10% yearly returns over a 20 year period.

If you don’t have the time to look at other investments, you can always wait. For example, there is almost 100% certainty that there will be a recession in the next 5 years and the S&P 500 will crash at least 50% like it did in the last two recessions. When it crashes, the CAPE ratio will probably be around 10, giving an expected long-term earnings yield of 10%.

Thus, it you invest a million now in the S&P 500 you will have $2,191,123 after 20 years. But if you wait 5 years and only then buy some good quality stocks on the S&P 500 with an expected return of 10%, your portfolio will be worth $4,177,248 after 20 years.

I can’t believe how short term the average investor’s analysis span is because nobody knows what will happen next month or in the next few years, but in the long term, everything is so easy to comprehend.

By the way, those who invested in U.S. bonds in 1982 enjoyed much better returns than those who invested in stocks. Hm, another concentrated portfolio…