Diversification definition: “the act or process of diversifying something or of becoming diversified.“
“Diversification is the only free lunch in finance.”
–Harry Markowitz (Nobel Prize-winning economist)
I admit it—I don’t fully understand either quote. Diversifying to diversify?
And why is the concept related to a free lunch?
In this post, I will try to sort out the strategy of financial diversification. Along the way, I hope to bring a little clarity to the quotes above. It is essential to understand why the wealthy use it as a powerful tool.
When you invest or use your resources, the act of diversifying means you don’t have all your eggs in one basket. And to keep this example culinary–instead of just eggs, you may have separate baskets with several different types of food.
Diversification is a process to ensure that you acquire and or/own different things. In the case of the wealthy, it applies to their investments in different kinds of businesses–or the desire to get multiple sources of income. In other words, they try to make sure that their income does not all come from one place or one kind of place.
A RECENT EXAMPLE OF DIVERSIFICATION
One of the most successful hedge fund managers on Wall Street, Bill Ackman, recently made a significant investment in Netflix stock. However, he recently sold at a $400 million loss on his $1.1 billion investment.
His rationale was that he had to sell when he received new information that contradicted his original reasons for buying.
Fair enough, but that is not the point. Mr. Ackman had the last laugh because he was diversified. He had invested in several types of stocks and investment vehicles. His performance is about eight percent better than the broader market at this writing. He did not have all his eggs in one basket, and it paid off.
DIVERSIFICATION: WHY THE WEALTHY GET MONEY FROM MULTIPLE SOURCES
The wealthy use diversification to protect their interests.
In one study, about two-thirds of self-made millionaires had at least three income streams. And the wealthier they are, the more likely they are to have more than that.
The logic goes as follows: the more places you get money from or have assets, the better your chances of surviving an economic downturn. And your income might rise too if things work out.
For instance, having just two sources of income of equal value means you only lose 50% in revenue and value if you lose one asset. In the case of having three sources of income, one complete failure reduces income by only 33% when all the sources of income are equal. It is simple math.
DIVERSIFICATION FROM OWNING DIFFERENT REVENUE SOURCES
Sheer numbers of revenue sources are not the only thing to consider. Multiple sources do not protect you if they ALL come from the same kind of business or investment. For instance, the revenue streams might all fail just because that business sector faces a downturn.
So, undiversified investment is risky. Placing all money in just one investment was responsible for the world’s first financial crisis in 1637. And that first crisis was instructive as to why diversification and common sense matter. So, let’s talk a little about that.
In 1637 many Dutch people decided that the road to wealth was lined entirely with investments in tulips–not hard work, crafts, or commerce—just flowers, nothing else. So, many Dutch rejected the conventional ways of earning a living for a short period. Instead, some people bought nothing but tulips as investments, and the prices went higher and higher.
They sold their businesses and household possessions to invest in tulips. They may even have consoled themselves with the idea that they were diversified because there were different kinds of tulips. And they believed they were only riding a trend—a trend that could go on forever.
And at first, that bet seemed like a good idea because the lucky investors who bought early made fortunes. But then, prices went up so high that the costs of some types of single tulip bulbs reached unthinkable levels. Prices for some tulips were ten times a skilled crafts worker’s yearly income.
But you can guess what eventually happened. The prices crashed. People who invested everything into just tulips lost everything. When the money gave out, tulips were just…tulips. It was history’s first financial bubble. And, if you have followed history, you know that the pattern has repeated itself repeatedly.
So just having a lot of income or net worth from only one asset is a little like getting a sack lunch and discovering that there are only apples in the bag. A boring lunch, but that is not the real problem.
If all the apples turn rotten before you eat them, you can go hungry. For some reason, my brain keeps making these examples all culinary.
DIVERSIFICATION BY ACQUIRING DIFFERENT ASSETS AT DIFFERENT TIMES
Most diversified assets are not all acquired at once. And that can be a huge advantage.
At each point in time, the best investment opportunities are different. The economy can be different from year to year and from decade to decade; interest rates fluctuate a lot from year to year. Technology can also change, and so the opportunities vary too.
Investors like Warren Buffett make their current investments depending entirely on the best current opportunity. For example, Buffett purchased 9.3% of the Coca-Cola Company decades ago, before management changes and a massive overseas expansion. That turned out to be an excellent use of money at the time and netted him over 18 times his initial investment. However, in 2020 he was a new equity investor not in carbonated beverages and drinks but Snowflake’s cloud software firm. So, he chose a completely different type of investment at a different time. It all adds up to a different kind of diversification.
Think about it like shopping at the supermarket. You buy apples when they are in season and cheap. You buy less when they are expensive. The same applies to pears, apples, or any other item you purchase. So, diversification by time and opportunity benefits you.
Many of the most successful people diversify their investments among different asset types, but they also diversify them by time and opportunity.
THE FLIP SIDE
Not everyone loves diversification for its own sake. Warren Buffett has also said, “There is less risk in owning three easy-to-identify, wonderful businesses than there is in owning 50 well-known, big businesses.”
The point is that diversification is more a strategy to keep what you have, but not as much to outperform everyone else.
CONCLUSION
The rich use the strategy more often than not. That may be why they remain rich.
Image: Timo C. Dinger
License: Unsplash