FTW INVESTMENTS

Investment Diversification Gone Wrong 

“Diversification is for idiots.” -Mark Cuban.

“Diversification is a protection against ignorance . . . Makes very little sense for those who know what they’re doing.” -Warren Buffett.

Mark Cuban and Warren Buffett are not fans of diversification. Idiot is a strong word, but Cuban isn’t referring to every type of investment diversification – just stock market diversification, which in his defense is foolish.

The general idea behind diversification is that it reduces risk – preventing any big losses in your portfolio. The problem is it prevents big wins as well. When you’re spreading risk through diversification, you’re diluting your returns on the risk-return spectrum.

Stock market diversification is like playing six hands at the blackjack table and betting the same amount on every hand. The odds are you’ll win three hands and lose three hands and come out even. Even if you win four hands and lose two, you watered down your winnings.

​​The skilled blackjack players don’t water down their winnings. Instead, they use their skill to maximize the returns on the one hand. In the same vein, skilled investors don’t water down their returns. They prefer to make educated investment choices.

Watered-down returns aside, the other problem with diversification is that it offers no protection from a crash.

AUTO Diversification.

Auto diversification is diversification in a box. It’s marketed by Wall Street for its convenience and sold as ETFs and mutual funds. Conditioned on the merits of diversification, the general public goes with the flow.

​​Investing in mutual funds and ETFs relieves them from picking the basket of stocks themselves. The ease and convenience of investing in mutual funds are why employees are content with planning their retirements through their employers’ 401(k) plans.

Need proof of watered-down returns from diversification? Just look at mutual fund performance:  92.43% of large-cap funds fail to be the S&P 500. As for protection from a crash, there’s no such thing.

​​In 2008, the running joke was that with the market crash, 401(k)s were turning into 201(k)s:  The nation’s 401(k)s and IRAs lost about $2.4 trillion in the final two quarters of 2008. In 2008, those aged 30-50 saw average returns of -30%, and over half of people over age 60 lost more than 20%.

Diversification is a buzzword Wall Street uses to take advantage of investors who want ease and convenience. But, unfortunately, the only ease and convenience derived from diversified products like mutual funds are the management fees mutual funds get fat from.

ACTIVE Diversification.

Not all diversification is bad. Active diversification is smart diversification. It’s mitigating risk without sacrificing returns. Ultra-wealthy investors like Warren Buffett and Mark Cuban are anti auto diversification, but they’re not against smart diversification.

​​Their portfolios are spread across multiple assets, but their diversification goals are different from the average investor because their investment goals are different from those of the average investor.

While the average investor is banking on their 401(k)s and portfolios appreciating over time, savvy investors are investing for income AND appreciation. Because of the income component – vital for building wealth through reinvestment – savvy investors allocate the majority of their portfolios towards alternative income-producing tangible assets like real estate, private equity, agriculture, and oil & gas.

The main advantages of investing in tangible cash-flowing assets are that:

  • They’re uncorrelated to Wall Street and less susceptible to downturns.
  • They appreciate over time.
  • ​Through smart diversification, their income streams can be protected.

Smart investors don’t spread their portfolios thin. They stick to one particular segment but diversify across multiple assets within that segment. That’s because concentrating on a particular segment is the key to building wealth. Real estate investors stick to real estate; tech investors stick to tech.

​​Focusing on one particular segment, you become knowledgeable and skilled in analyzing deals in that segment, which allows you to invest passively by leveraging the skill and experience of others across multiple geographic locations with varying exit strategies and different compensation structures and terms.

​​By sticking to one segment like real estate, investors are more able to confidently and competently screen passive opportunities because they know how to analyze deals.

“Diversification may preserve wealth, but concentration builds wealth.” -Warren Buffett.

Don’t auto diversify on Wall Street; actively diversify in the private markets. Focus on what works and diversify across multiple geographic locations, compensation structures, terms, and security types, to preserve cash flow and appreciation insulated from downturns and inflation.

Why water down returns with no downside protection?

​​Wall Street auto diversification only dilutes your returns while offering no protection from a crash. Not putting all your eggs in one basket doesn’t help when the warehouse (stock market) where you keep those baskets burn to the ground.

Through smart diversification in the right assets, not only can you mitigate risk but preserve returns. It’s the only type of diversification that makes sense for the savvy investor.

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Logan Freeman

Building generational wealth with alternative investments