Diversification: Preparing for the Next Surprise

Probably only one thing is certain: The world is still full of surprises yet to be revealed. Is your portfolio diversified in preparation for the next one?

If anything, the COVID-19 pandemic has certainly reinforced the idea that uncertainty is an ongoing part of life on this planet. “Surprises” occur every day, so much so that being surprised should not really be surprising to us!

Nobel Laureate Daniel Kahneman quipped that, “The correct lesson to learn from surprises is that the world is surprising.”

Diversification, as an investment strategy, takes this lesson seriously. Diversification is NOT a short-term approach to maximizing returns but a long-term strategy to raising the probability of ongoing portfolio survival.

For an investor to genuinely maximize their return, they would have to own the single best performing asset each day markets were open. Looking at market data in the Wall Street Journal for July 8th, 2020, an investor trying to maximize return would have wanted all their dollars invested in a small insurance company, National General Holdings Corp. (ticker NGHC on the NASDAQ) at the market’s opening bell. The shares of this company were up almost 65% in the first 90 minutes of trading that morning. On the flip side, an opening bell investment (bet?) in MOGU, Inc. would have resulted in a 30% loss of wealth in those same 90 minutes.

Most thoughtful investors understand that the probability of selecting the single best performing asset each day of every year is as close to zero as one can get. Because we know this intuitively, we naturally choose to own more than one asset, a portfolio of assets, to hedge against extreme, negative surprises. This instinct to “hedge our bets” is the basic idea behind diversification.

Today, instead of owning the stock of one company, we can choose to own the stocks of thousands of companies with different characteristics around the globe: low price value companies, small companies, companies with quality earnings and profits, companies whose stock prices are showing positive momentum or whose stock price has low volatility. Academics have shown that all of these “factors” affect stock prices differently, enabling equity investors to diversify more effectively. Investors can also own debt securities (bonds) issued by companies and governments. Real estate, commodities like oil and gold, as well as FDIC insured cash may also be part of an investor’s diversified portfolio.

The trade off that comes with the downside protection of diversification is the inability to absolutely maximize your return. By holding a portfolio that owns anything other than the best performing asset, the investor accepts a lower than maximum potential rate of return to minimize a potentially catastrophic loss. However, while diversification may preclude absolutely maximizing the rate of return, it does enable investors to enhance their risk adjusted rate of return which, for most investors, is a more important measure of success.

In 2020, the top performing stocks in the world have been those of technology companies, especially in the internet related data and communications sectors. Many of these companies are offered (listed) on the NASDAQ exchange. The NASDAQ 100 (the 100 largest stocks on the exchange) is available for investment through an Exchange Traded Fund (ETF) with the ticker QQQ. This ETF has been available to investors since March 10, 1999. In 2020, QQQ was up over 20% through July 7th, while most other stock market measures were negative. For return maximizing investors, these technology growth stocks can seem very attractive. Today, the idea that internet enabled businesses will not continue to do well in the future seems very unlikely.

On March 9, 2000, just about one year after QQQ began trading, it reached a price just above $100 / share. On March 10th, QQQ began to decline and would not recover to its March 9th high until February of 2015, almost 15 years later. Even though the future of internet enabled companies seemed undeniably bright in the late 1990’s, the dot.com bubble still burst, and investors hoping to maximize return by holding the growth stocks of these internet enabled businesses were unhappily surprised.

During the next 15 years, as technology companies struggled to come back, most of their stock prices declined precipitously. Some companies went bankrupt, and some survived. In the year 2000 alone, seventeen of the 100 companies making up the NASDAQ 100 were “kicked out” of the index as their business valuations declined or vanished. In 2001 another nineteen companies were removed.

During the years leading up to the Great Financial Crisis of 2008 and 2009, assets including real estate investment trusts (REITs), the stocks of many companies outside the United States, companies with low valuations (value stocks), and bonds, all performed better than the technology heavy QQQ.

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Source: Morningstar Direct

The moral of this diversification story, like many others, is not that technology companies are unusually risky long-term investments, nor that international companies, value stocks, or real estate investment trusts are better long-term investments. The lesson of history is that a portfolio diversified among various investments is less likely to experience a single, surprising catastrophe that can sink the portfolio and along with the goals and financial plans of the investor.

Uncertainty is always a part of investing. In retrospect, we may be tempted to think that we should have seen the surprise coming. In this case, we were aware of COVID 19 early in 2020, as it created a seemingly limited impact in China. At that time, who knew that, in just a few weeks, we’d be working from homes, relying on technology as never before, and watching the stock prices of most companies decline in recession while a few technology companies would profit from the surprising series of events? Probably only one thing is certain: The world is still full of surprises yet to be revealed. Is your portfolio diversified in preparation for the next one?

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