Diversification is not the Holy Grail

How is an investor to know in which asset class to invest? The common, mainstream answer is diversification. Mainstream financiers preach their gospel of diversification: “Own every stock in the world, own every bond in the world, own every possible asset.” Really? Should an investor always own stocks when they reach record high price levels compared to earnings? Should an investor always own stocks or bonds in companies that are weeks or months away from bankruptcy? The answer is no if the investor is willing to put in some work and brainpower. Warren Buffett once said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Mark Cuban puts it a little more bluntly: “Diversification is for idiots.” If an investor wants to simply set away money and forget about it, diversification is the way to go. If an investor is unwilling to spend hours upon hours studying the correct ways to invest, the investor should diversify. However, if an investor is willing to put in the time and brainpower, much better opportunities exist.

The premise is simple: no investment is superior 100% of the time. Sometimes stocks perform well, sometimes bonds perform well, and sometimes precious metals perform well. They usually do not perform well at the same time. The investor must determine which investments will perform best in the mid to long term given the state of the world in which the reader lives.

How is an investor to determine whether to allocate capital to stocks, to bonds, or to precious metals? First, the investor must form his or her secular macroeconomic outlook. Secular is finance talk for “long term.” Macroeconomics looks at the state world economies as determined by interest rates, growth rates, inflation, and other factors. An investor’s secular macroeconomic outlook, therefore, is his or her long term forecast about what world economies will do. According to his or her secular macroeconomic outlook, the investor can determine in which asset class to allocate capital.

I believe an investor can gain a general idea as to which asset class to invest on based on two factors that drive all investments: the growth rate of the economy and inflation. The following chart stratifies the state of the economy and inflation and accordingly tells which investments can be expected to outperform.

 

Secular Macroeconomic Outlook for the Economy and Inflation

Low Inflation High Inflation
Bad Economy Bonds Precious metals, inflation protected bonds
Good Economy Stocks Some stocks, precious metals

 

The investor should absolutely not invest based on the current state of the economy and the current inflation rate. Instead, the investor should allocate assets based on his or her secular macroeconomic outlook for the economy and inflation. Why? It all goes back to the number one mantra of investing: buy low and sell high. On average, economies grow for about seven years and shrink for about two. So, when the economy has been great for seven years, the investor’s secular macroeconomic outlook may say the economy and stocks are probably near their peak. The investor should not invest in stocks when they are at their peak. His or her secular macroeconomic outlook will tell the investor stocks may not perform well in the future. Therefore, according to our chart, either bonds or precious metals would be better bets than stocks. The investor can then form a macroeconomic outlook for inflation also and determine whether regular bonds or precious metals and TIPS will perform better.

The bottom line: diversification can offer good returns. However, you can achieve better returns and potentially lower risk if you know what you are doing. For example, you could diversify to extremes and buy 1,000 different stocks through a mutual fund. If the stock market falls 50%, you will lose 50%. However, if you were to do research and choose, say, five safe stocks, your portfolio may lose only 25%.

For another perspective, check out this video of Mark Cuban’s approach to investing. He believes that investors should simply accumulate cash until a good investment opportunity arises, then spring into action and go all in.

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