In this podcast episode you’ll learn:
- The skills you need to be able to select individual stocks.
- How have active managers outperformed relative to passive indexing products.
- How much diversification is too much and a test to determine if one is over diversified.
- What is factor investing and which factors have worked over the past 200 years.
Become a Better Investor With Our Investing Checklist
The idea of over-diversification can be complicated in nature. In its most simple definition, it is when a growing number of investments in a portfolio (which can lower risk) also overly lowers the expected return. You have to weigh whether the lowered risk outweighs the potential cost. In this episode, David unpacks the concept of diversification and answers a listener question about passive versus actively managed funds.
Diversification is a protection against ignorance
Warren Buffet once referred to diversification as a “protection against ignorance”. The majority of the general public does not understand how to evaluate businesses well enough to know how they should be valued. .
So if you’ve already decided you don’t have the expertise to select individual stocks and instead use index funds and ETFs how do you know if you’re over diversified? How do you know that the manager you’ve chosen was the best option? David states, “if you’re paying too much, in terms of the transaction costs and management fees vs. the marginal benefit of reduced volatility, then you’re over diversified.”
An advisor isn’t necessary
As an investor, you have two choices in front of you: investing in a fund with an active manager, or some sort of passively managed fund, such as an index fund, or exchange-traded fund (ETF). According to David, the likelihood of an advisor outperforming an existing portfolio of Vanguard Index Funds is small.
Morningstar, a global financial services firm that performs investment research, made easy work of the subject in a study they performed. In 15 years, only 15% of large-company funds were successful in outperforming the index. With dismal numbers like that, the investment in an active manager likely won’t get you a return on your money. David used to choose managers in his profession and found that even if you find a skilled manager, they too go through lengthy periods of underperformance.
Individual investors should use index funds
Warren Buffett wrote in his 1996 annual shareholder letter that he recommends investing in an index fund that charges minimal fees. This will lead to a higher chance of succeeding.
On the flip side, if you are bound and determined to choose your own individual investments, you have to have the necessary skills to evaluate specific businesses. If you do so, choose industries with your circle of competence. Where does your experience and expertise lie? Work with what you know, and invest in something you are certain will continue to succeed in the next 20 years.
You also have to be able to pinpoint companies that are mispriced and likely to outperform. Not many people are capable of doing that—even Warren Buffet—and it will likely reduce your return. With the market being so volatile it may not be in your best interest to manage individual stocks yourself.
Considering factor investing
A paper titled “Global Factor Premiums” written by Guido Baltussen, Laurens Swinkels, and Pim Van Vliet gave David a comprehensive overview of factor investing over a period of 200 years. What they found was that most factors work:
- Momentum: Stocks that have had high returns will likely continue to have high returns. This study showed that momentum within stocks had a positive Sharpe ratio.
- Value: worked 75% of the time in rolling 10-year periods.
- Trend: The idea that an upwardly biased market continues—worked 98% of the 10-year periods for stocks.
- Seasonality: The fact that there are certain months of the year when stocks do better. This worked in 90% of the 10-year periods.
- Carry: As long as nothing happens, you continue to get paid. Carry worked 95% of the time, on a rolling 10-year basis, in terms of a positive Sharpe ratio for stocks.
- Betting against beta: Volatility relative to a particular benchmark. This also had a positive Sharpe ratio.
These factors are persistent drivers of return. David dives into answer this particular listener’s questions in detail, delving into the positives and negatives, and his thoughts on possible decisions that could be made.
- [2:22] Exploring the concept of over-diversification
- [5:25] Should you pay for an investment advisor to select individual stocks?
- [8:05] An individual investor should choose index funds
- [11:10] Determining how much diversification is enough?
- [13:37] Weighing the cost against the benefits
- [16:10] When being over diversified is possible
- [17:05] Analyzing the listener question regarding over-diversification
- [20:20] A Fascinating study analyzing 200 years of factors
- [25:08] Layer on additional value factor
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein. Today is episode 275. It’s titled, “Are You Over Diversified?”
I recently received an email from a listener who wrote, “First, I want to say that I have been listening to your podcast for about 6 or 7 months now. I’d like to thank you for providing a large breadth of knowledge on topics that I find useful. Your podcast is one of the few that I share frequently with friends and family. Thank you. Anyway, my questions are: first, should I consider using a financial advisor at the cost of 1.5% of funds under management? I feel as if I’ve done fine managing my and my wife’s retirement money, so far. Together we have saved $540,000 at the age of 40.
“Our retirement money is invested in low-cost, passively managed Vanguard funds. Approximately 50% in the Vanguard Total Stock Market Index Fund, 25% in the Vanguard Total Bond Market Index Fund, 15% in the Total Vanguard International Stock Fund, and 10% in the Vanguard Real Estate Index Fund. After speaking with the advisor whose firm does it’s own research and invest their customers in specific holdings held at a third party brokerage, he analyzed my current portfolio and mentioned that I’m over diversified, 10,963 stockholdings, among other selling points.
“Second, alternatively, is it worth considering switching to actively managed funds, at a slightly higher cost, where I’d feel like I’m maintaining a little more control, but I could avoid the stated ‘over-diversification’. The portfolio below is what I’m considering and mimics what I was already looking to phasing into as the market eventually corrects, awaiting 5%, 10% declines using Vanguard Index Funds.”
The portfolio he’s considering is 50% T. Rowe Price Small-Cap Values Fund, 25% Dodge and Cox Large Value and the Vanguard Wellington Fund.
He concludes, “I’m just looking for an outside opinion from someone who doesn’t have anything to gain from the choice.”
Is diversification a bad thing?
Now we’ll analyze this listener’s current portfolio versus the proposed portfolio in a bit. But let’s first explore this idea of over-diversification. Is this is a bad thing? Is it possible to be overly diversified, or too diversified or what’s sometimes called “de-worse-ification.”
In the 1996 Berkshire Hathaway Annual Meeting, Mark Hake from Scottsdale, AZ asked Warren Buffett about diversification. Hake had noted that the number of public equity holdings in Berkshire’s portfolio varied from year to year. Hake said, “I am very interested in your policies on diversification and how you concentrate your investments.”
Here’s what Buffett replied, “You know, we think diversification is, as practiced generally, makes very little sense for anyone who knows what they’re doing. Diversification is a protection against ignorance. I mean, if you want to make sure that nothing bad happens to you relative to the market, you own everything. There’s nothing wrong with that. I mean, that is a perfectly sound approach for somebody who does not feel that they know how to analyze businesses. If you know how to analyze businesses and value businesses, it’s crazy to own 50 stocks or 40 stocks or 30 stocks, probably. Because there aren’t that many wonderful businesses that are understandable to a single human being, in all likelihood.”
He’s saying diversification is protection against ignorance. Ignorance being a lack of knowledge, not knowing what is going to happen. He’s also saying, if you want to make sure nothing bad happens to you, then you own the market. And bad in this case would be underperforming the market. Is diversification a bad thing and a sign that we’re ignorant?
Those comments by Warren Buffett about diversification are what he said at the annual meeting and he was really targeting money managers, who are trying to find what they classify as “super wonderful businesses.” They suggest that there’s just not that many of them, so when you’re adding more and more holdings, they feel that that’s madness.
But here’s what he said in the actual annual letter, geared toward us as individuals. Buffett writes, “Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results after fees and expenses, delivered by the great majority of investment professionals.”
Active versus passive management
This listener is asking, should he pay 1.5% per year for an investment advisor to select individual stocks. Absolutely not. The likelihood of that advisor outperforming their existing portfolio of Vanguard Index Funds is very, very small. Morningstar twice a year does an active/ passive barometer. And they write that the central question they’re trying to answer is, “If an investor were trying to select an actively managed fund at random, from a category, what are the odds that fund will survive and outperform its passive peers at any given time period?”
We have a choice: we can hire an active manager, in the case of this particular advisor, a separately managed account. Or potentially a mutual fund, or we can invest in an index fund or ETF. Morningstar compares the two strategies, by category, and shows what the performance has been for active funds vs. passive.
And what they show is dismal, the performance. I’ll just focus on the 15-year category. U.S. large-company funds, only 15% were successful in outperforming the index. Mid-cap, a little better, about 27%. Small-cap, roughly 25%. Foreign Large Blend, 31% over the past 15 years. World Large Stocks—so global—29%. U.S. real estate, 33%. Intermediate Core Bond: 17%.
Now, this is over longer periods, 15 years. 10-year periods are just as bad. So if you’re randomly selecting, let’s say mid or small or foreign, two-thirds underperform the benchmark, one-third doesn’t. Do you have the skill to identify who those managers are? I used to do that professionally, select outperforming managers, my team and I. Very, very difficult to do. Often, we were unsuccessful or maybe they had the qualities we were seeking, but even outperforming managers, skilled managers, go through lengthy periods of underperformance.
As a Money For the Rest of Us Plus member, you are able to listen to the podcast in an ad-free format and have access to the written transcript for each week’s episode. For listeners with hearing or other impairments that would like access to transcripts please send an email to [email protected] Learn More About Plus Membership »