Fore!
Today, let’s discuss diversification.
But first…
Golf.
What an interesting sport, right?
A sport welcoming to all, yet few will ever truly master the game. The dedication and practice it would take to become an “expert” is no small commitment.
In golf, we have selective memories, a bad round will be forgotten easily, but that one great shot of the day will keep us coming back for more punishment. (If you haven’t had the pleasure, take a moment to enjoy Robin William’s take on golf: Robin Williams Explains Golf)
Golfers come in all shapes, sizes, and ages. and is one of the sports that is hard to judge talent simply by appearance. Sometimes the eldest in the group is the best of the bunch. Sometimes the most decorated player with all the new equipment and attire could be the biggest disappointment in your foursome. It’s wise to never judge a book by its cover when it comes to golf.
A Friendly Wager
Because you can often have such a wide array of talent all golfing together, golf is full of games within the game. Everything from a Texas Scramble to Skins to Bingo, Bango, Bongo! These “Games within the game” add some financial incentives to the match and can help engage the novice participants to compete along the way.
Here’s a fun one, have you heard of Battle Golf or Bag Raid? The rules are simple, if you post a better score on a hole than your opponent, then you get to take a club out of their bag. You continue this hole by hole, with the winner of each hole choosing to take a club out of their opponent’s bag or take back a club they lost on a previous hole. The challenge, or humor here, is that each club in your bag is the right tool or match for a certain distance or type of shot, and as you lose some of your tools, you are forced to be a bit more creative in how you approach the game.
Club Count
The Professional Golf Association (PGA) allows players to carry 14 clubs when participating in one of their sanctioned tournaments. Although some golfers may wish for a few more specialized sticks to bring along, this 14 number does seem to be the sweet spot. In Bag Raid, when you go on a multiple-hole losing streak, and you find yourself playing with just 4 or 5 clubs (driver, putter, and a few irons), it can make an already difficult game [golf] that much harder.
Now, let me ask you this, it is obvious that the more we reduce the club count, the more difficult the game becomes, but is the opposite true? If we were to allow you to play with 20 clubs, 50 clubs, or 1,000 clubs, would each incremental increase in club count incrementally improve your score? The answer is no. We have a name for this in economics, we call this the law of diminishing return.
Here is what we conclude, club diversification is important for a successful round of golf, but this principle has a limiting impact after we hit that sweet spot around 14 clubs. Investing isn’t too dissimilar; diversification is a key tenet to investing, but there is a diminishing return aspect as well.
From Sand Wedges to Stocks
Here at The Bahnsen Group, our Founder and namesake for the firm, David Bahnsen, wrote a book outlining our primary investment strategy, The Case for Dividend Growth: Investing in a Post-Crisis World. This Dividend Growth portfolio, which we refer to as Core Dividend, is made up of approximately 30 individual businesses (stocks). This number of securities was not chosen at random, it is much like that of a golf bag holding 14 clubs. At 30 securities, our investment committee, and our team of analysts, can know each of these businesses intimately, AND we can enjoy most all of the benefits of diversification.
Just like 1,000 clubs in our bag wouldn’t transform us into a golf Hall of Famer, more securities won’t continue to meaningfully reduce risk/volatility. The “why” is the important part here. When investing, we are facing two different types of risk – Business Risk and Market Risk. Business risks are the risks unique to that one particular business and how individual circumstances or events can uniquely impact that one business versus the entire industry or market. Perhaps a CEO is revealed for his or her scandalous activities, or a lawsuit comes forward against that business or financial troubles birthed from overspending and overborrowing. As a hypothetical, if one owns 25 individual stocks equally, this means the greatest concentration in one business is 4%. Sure, one should have other prudent risk management measures to diversify across industries and be aware of interest rates or commodity sensitivities prevalent in the businesses they own, but in general, this maximum concentration – in this example – of 4% is meant to diversify away from that individual business risk. If an unforeseen and unfortunate event occurs to one of those portfolio companies, even a 50% hit to the downside would only surface as a 2% drop to the portfolio – we call this attribution.
What Diversification Doesn’t Solve For…
Market Risk, on the other hand, can’t be diversified away. Stocks as a whole, as a peer group, as a conglomerate will have a strong correlation to one another. Sentiment ultimately drives markets, and that market current is what will pull the “stock market” directionally and in unison.
Furthermore
Thus far, we’ve focused on diversification within an asset class, using our Core Dividend strategy as our example. Here at The Bahnsen Group, we are also big advocates for diversifying a portfolio across different asset classes or strategies. Again, for our team, that core portfolio is often the foundation or primary building block of a portfolio, and then we do what I often like to call layering. We layer other strategies (allocations) on top of that core portfolio, and these are not intended to be strategies with high correlations but rather investments that will behave differently. Our intent is not to create redundancies as we add allocations but to layer on non-correlating strategies to further improve the diversification of the portfolio. Going back to our golf analogy, it would be of little value if you added another 9-iron to your bag, but perhaps a different degree wedge or a hybrid club might bring that additional diversification you are looking for.
When offering a non-client a complimentary review of their portfolio, this is where the sequence of questions will often start – “Tell me about how this portfolio was designed and how all these pieces fit together?” Our stance is that each puzzle piece (allocation) should have a rhyme or reason for why it is in the portfolio, and each allocation should match an objective that is easily revealed in the financial plan.
Blemishes
When a golfer heads to the 19th hole (aka the bar), they will often debrief their round. This debrief will reveal what parts of their game were strong and what parts of their game were weak during that round. Perhaps their short game was above average, but they were not hitting fairways as they are typically accustomed to. At the end of the day, each golfer’s scorecard reflects one final score, even though it was made up of many parts (shots). An investment portfolio is the same, if you are diversified, then some aspect of your portfolio will always feel a bit weak throughout one particular round (year). And that is ok! The focus is not on the parts but on the whole; the outcome. This year it can feel frustrating to own stocks in the emerging markets, but you might be very thankful for some of the energy names you own. I am sure bonds have disappointed you beyond your expectations in 2022, but hopefully, your alternatives have represented a silver lining. This is diversification, this is reality.
Puzzled
I know I am a broken record, as I say this often, but this is why each of these allocations that make up your portfolio are different puzzle pieces. They fit and complement each other, and each of them helps to reveal the picture that is your financial plan. As you build this puzzle, there will be every shiny object investment and fearmongering headline attempting to distract you from the primary focus – your financial plan. Keep your eyes on the prize, my friends. The longer I work in this profession, the more convinced I am that behavior trumps all. The majority of financial wreckage I see has little to do with owning the wrong investments and a lot to do with how the investor misbehaved. Hence, job security for me, I suppose.
The recap here is simple, diversification is important and also limited. Understanding what risks you can and cannot reduce with diversification is important. And you should be aware that diversification is going to invite blemishes into your portfolio – not every shot on the course will be your best. A plan is key, and a portfolio that specifically supports that plan is clutch. This will save you from always trying to redesign your approach to the ever-changing economic landscape that surrounds you. This is also, unintentionally, an advocation for resourcing an advisor – someone to help craft a plan, be intentional about how exactly the portfolio should be designed, hold you accountable, educate you, and comfort you when it gets difficult to follow that plan because it will get difficult.
These are the laws of personal finances, these are some of the rules of the game. If you want further clarity or if this discussion sparked questions/comments, please don’t hesitate to send me a note. You can reach me at tcummings@thebahnsengroup.com.
Until next week, friends…
