Sunday, August 7, 2011

Investing 101: Diversification Is A Scam

Hello All:

It's been awhile since I've posted, but I'm trying to get back in the game and be more consistent about posting.

One of the biggest misnomers of the investment world is the theory of diversification.  The financial system does not surround around finding the best, most intelligent investors that seek out exceptional investments to provide better-than-average returns.

Investment firms have pushed this strategy for years. One of my personal favorite's is the quote from Jim Rogers...

""Diversification is something that stock brokers came up with to protect themselves, so they wouldn't get sued [for making bad investment choices for clients]. Henry Ford never diversified, Bill Gates didn't diversify. The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket. You can go broke diversifying. Ask anyone who's diversified in the last three years. They've lost money."

In today's environment, you can't simply pick a pre-grouped class of stocks, etfs or bonds and hold onto it for several years hoping to achieve extraordinary returns. No, that no longer holds up in this environment.

This chart is the cornerstone of most investment firms. Let's break down how ludacris this chart actually is...

In the above figure, it says that only 4.6% of portfolio performance is attributed to how well your portfolio performs. If this were true, why would you even NEED a financial advisor? You'd simply pick a handful of stocks and let it ride, right? Do you really think that, for example, picking 5 quality oil drilling companies with a history of strong performance and some of the top researchers in the field versus picking the worst companies with the worst performance and a bunch of bumbling idiots will produce the same results within say, oh, 4.6%?!

Of course not! Yet, this myth is perpetuated again and again by financial advisors by claiming that "all this is irrelevant as long as you pick the right asset classes." Here's the secret to investing in a nutshell...

Picking the right sectors, the right companies, and the right countries... AT THE RIGHT TIME!

Doesn't this seem obvious? Yet, people continually follow this poor investment advice.  

In addition, modern portfolio theory suggests that diversification "limits risks" and "diversification protects your portfolio" and other claims.  But, what never seems to be discussed is the fact that it also virtually eliminates the possibility of ever achieving any sort of above average or extraordinary returns. If you select a basket of 50 stocks, for example, and you have a stock that achieves a 300% return, it really makes very little difference to your overall portfolio.  The "jack of all trades" approach may work for some areas of life, but I prefer to avoid this with regards to investing.

I sometimes like to use sports in my analogies as many people can relate to these analogies.  So, if a football teams offensive approach can run the ball at a mediocre level, pass at a mediocre level, and block with mediocrity, then it's likely they will be a mediocre team.  However, if you have a football team that is the MASTER of just a few key points of the game, and has the ability to exploit the defense whether it be through a certain running scheme or passing attack, and can consistently dominate the defense and exploit the defense time and time again, I'll take my chances with that team and bet they win 99 out of 100 times.

If you have an investor that is the MASTER of one specific asset class, and knows they ins and outs of energy, or transportation, or biotech, or whatever the case may be, they stand a much better chance to achieve exceptional returns.  For this reason, I think over diversified mutual funds, etfs, and others are horrible investments.

So why is it that this theory has been around for so long? Well there's a few main reasons.  For one, it allows financial advisors to conceal their ignorance and lack of expertise. Two, it gives a cookie-cutter solution so that financial advisors may continue to do what benefits them the most, collecting more assets.

You see, a financial advisor makes money by collection more assets under management.  That's the name of the game! You collect more assets, you make more money.  For example, the average investment advisor makes around 80 basis points (or .80% of the total assets under management). Very little, if any of their compensation is based on how much their investment assets perform.

You may here the argument, "Yea, but, if the investment advisor makes you more money, that increases their assets under management, and they make more money! So, they do have a vested interest in my performance."

Ok, let's play this scenario out a little bit more. Let's say that you give an investment advisor $1,000,000 of your hard earned money to manage.  That means, they make about $8,000 (or .80%) each year for managing that money.

What if, for example, they dedicate 1000 hours to research and generating performance of your money each year. By doing that, they are able to achieve an extra 5% annually on your money and the other $10,000,000 they have total under management (this would be considered a small management firm). They would generate approximately $4,000 in extra income for themselves.

But, let's say they spent 1000 hours on gathering assets and generating more clients instead of trying to improve their current assets. If they grow their business by only $1mm over the course of the 1000 spent marketing and gathering new clients, they would generate an $8,000 profit for themselves, approximately double the return.

I realize these are fabricated numbers, but it's only meant to illustrate that, in many, many situations, it's much more time efficient for a financial advisor to concentrate on gathering assets, than Improving upon the assets that they already have under management.

More Later,

More coming later

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