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A reader recently wrote to challenge my belief in diversification, citing a couple of accomplished investors who said, in effect, that anybody who diversifies an investment portfolio must be an idiot or a moron.
The statements came from billionaire entrepreneur and television personality Mark Cuban and from Charlie Munger, vice chairman of Warren Buffett’s Berkshire Hathaway BRK.A, -0.66% BRK.B, -0.37%.
If they are right, then I’ll plead guilty, because I’m a firm believer in diversification — both for myself and for almost all the investors I’ve helped over the past half-century as an adviser and educator.
Diversification is one of the most important steps every investor should take. Tons of evidence is on my side — and I’ll share some of it with you.
Warren Buffett is chairman and chief executive of Berkshire Hathaway and is probably this century’s most widely admired investor. He provides investors with what I think is a mixed message about diversification.
On the one hand, he runs a multinational conglomerate holding company that owns a portfolio of interests in media, real estate, transportation, food, insurance, housing, clothing, retail, aerospace, banking, utilities, restaurants and technology — among other things.
That list does not make a strong case against diversification.
On the other hand, Buffett has been quoted repeatedly over the years as putting down the concept of diversification.
For example: “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.” Instead, Buffett recommends index funds for most investors, especially ones that follow the S&P 500 index SPX, -0.47%.
I’ll return shortly to the notion of “those who know what they’re doing.”
But first, let’s look at Berkshire Hathaway: Since 1965, the company’s stock has compounded at more than 20%, and that’s the story most investors know.
However, that history goes back 56 years. Let’s look at some more recent results.
At Morningstar, I found the following comparisons, which use the Vanguard 500 Index Fund VFINX, +0.58% as a proxy for the S&P 500, as of Dec. 14, 2020:
Most recent five years: S&P 500 15.3%; Berkshire Hathaway 11.7%.
Most recent 10 years: S&P 500 13.8%; Berkshire Hathaway 10.9%.
Most recent 15 years: S&P 500 9.5%; Berkshire Hathaway 9.3%.
Berkshire Hathaway certainly has diversification, with full ownership or stakes in about 50 companies. Those stakes were carefully chosen by Buffett.
But the company’s returns in the recent past have failed to match those of the S&P 500, which includes 10 times that many companies, including plenty of dogs.
One thing I know is that even a 0.5 percentage point increase in return can easily be worth $1 million to an investor over a lifetime.
In the past five years, Berkshire Hathaway lagged the S&P 500 by more than seven times that much. In the most recent 10 years, the difference was nearly six times that much.
In these comparisons, more diversification (500 companies) had a higher payoff than less diversification (50 companies).
There’s a second element here, one that can also be worth $1 million or more over an investing lifetime: Active management vs. passive management, as in index funds.
Millions of investors are drawn to the lure of active managers who seem to have “something special.”
Recall Warren Buffett’s statement that diversification “makes very little sense for those who know what they’re doing.”
Confident that he knows what he is doing, Buffett does not practice full diversification. But over the past 15 years, his knowledge did not produce superior returns.
I used to give regular talks to high-school students, and my talk included this question: Would you rather invest like a millionaire, or like a poor person? These young people were all smart enough to want to emulate millionaires.
Poor people, I told them, typically invest in a few stocks, while millionaires invest in thousands of stocks.
Today any investor can own parts of hundreds or thousands of companies through low-cost index funds and exchange-traded funds.
Just for fun, think back 15 years ago, to the last weeks of 2005. Imagine somebody had suggested that Berkshire Hathaway should replace everything it owned with one simple investment: an index fund tracking the S&P 500 index.
Most people would have scoffed at such a ridiculous idea, and the majority of Berkshire Hathaway shareholders probably would have sold their stock and taken their money elsewhere.
When it comes to active managers, Buffett is as good as they come. But the natural optimism of human nature tricks our brains into thinking we know more than we actually do. I don’t think Warren Buffett is immune to that.
As an investor and a teacher, my job is to harness the probabilities of success.
Nearly a century of investment returns tells me that a diversified portfolio of stocks and asset classes is much more likely to pay off than a portfolio that relies on a much smaller number of stocks chosen by managers who, in Buffett’s words, “know what they are doing.”
So today we have two lessons in one: First, diversify. Second, use passive management instead of active management.
Index funds relieve investors like us from the burden of “knowing what we’re doing.” Index funds let us do well — in fact they almost guarantee it — despite our ignorance.
Here are the very worst 40-year compound returns in several U.S. asset classes over the past 92 calendar years, from 1928 through 2019:
• Large-cap blend stocks (the S&P 500, in other words) 8.9%
• Large-cap value stocks 8.8%
• Small-cap blend stocks 10.7%
• Small-cap value stocks 11.6%.
To repeat: Those are the worst long-term returns.
Each of those asset classes is accessible to today’s investors in low-cost index funds and ETFs.
Buffett seems to believe that “knowing what you’re doing” involves picking stocks and businesses.
My own definition of “knowing what you’re doing” includes diversification, using passive management, and understanding asset classes such as the four I just listed.
For any investor with several decades left, a terrific portfolio can be built with equal parts of ETFs or index funds representing those four asset classes. That’s simple and inexpensive. And history suggests it carries a high probability of success.
To my mind, that’s the opposite of what a moron would do.
Richard Buck contributed to this article.
Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways To Supercharge Your Retirement.
