A debate recently resurfaced surrounding investment diversification and whether spreading your bets across many asset classes and securities is the best way to protect your portfolio. Roger Ibbotson of Ibbotson Associates, which is now owned by mutual fund ratings firm Morningstar, chimed in last week that diversification didn’t fail investors in recent years, but other investors aren’t so sure. This discussion also has implications for small business owners in terms of product and geographic mix.
The Downside to Diversification
Ibbotson’s claim is that while stocks and most other asset classes plummeted in 2008 and have yet to recover, asset classes including bonds and cash have performed very well, with the first in the midst of a bull market that has lasted since the 1970s as interest rates have continued to fall. Cash is also king, as the saying goes, and is of high value in a falling market environment as it tends to hold its value – as long as inflation stays low.
However, it was certainly surprising at how most assets, including commodities, stocks, real estate, private equity, and many corporate and related fixed income securities, all fell dramatically during the height of the credit crisis. Worse yet, selling occurred across global financial markets.
Diversification can provide benefits during more stable market environments or when the focus is on simply matching the return of passive asset indexes. However, many savvy investors carefully study the risk of individual securities and build portfolios from the bottom up. This philosophy is embraced by Mohamed El-Erian, the current head of Pimco, who suggests looking at the riskiness of each individual asset.
The Bottom Line for Investors and Small Business Owners
Warren Buffett and likeminded value investors, including Don Yacktman of the Yacktman Funds and Bill Miller of Legg Mason Capital Management, also invest using this mindset and focus on selecting a smaller basket of securities with higher expected returns. This is the essence of risk management in their eyes, which can also be described as holding your eggs in one basket but watching that basket extremely closely. For them, investing consists of selecting businesses with strong underlying fundamentals that are built to withstand the ups-and-downs of the business cycle and fickle stock market sentiment.
From a business perspective, diversification stems from spreading sales across multiple product lines and geographies. Small business owners whose net worth is concentrated in operations that consist of a small basket of product offerings or regional exposure must also prudently manage risk. Those that specialize in refraining from spreading themselves too thin can become extremely successful, as do investors that know what to look for in finding compelling companies to invest in.