-By Joseph Gomez

There is a pretty public debate going on between Vanguard founder, Jack Bogle, and Mavericks owner, Mark Cuban.  In an interview in the Wall Street Journal, Cuban basically said, “buy and hold is a crock” and “diversification, that’s for idiots.”

On the other hand, Bogle says that diversification generates returns while hedging the market, and that’s what the average investor (not Mark Cuban) needs. He continues, “For the average investor that doesn’t want to spend his life consumed with investing–and should not spend his life consumed with investing–he should get a nice simple strategy of diversification, not only by asset class–that is to say, stocks and bonds largely–but by the number of stocks and bonds in each class, a thousand even.”

So who’s right? Actually, both are. Diversification is a strategy to reduce risk whereas concentration is a strategy to enhance returns. Put another way, a correctly diversified investment strategy is intended to preserve wealth while a highly concentrated strategy is to amass great wealth.  Whether you concentrate in cattle, oil, private business pursuits or common stock, a highly concentrated approach can lead to a great payoff, albeit, with much higher risk.

Billionaire investor Warren Buffett is possibly the best-known advocate of a concentrated portfolio, once suggesting that investors make no more than 20 decisions in their lifetime about what to buy or sell.  A quick review of his fellow billionaires also confirms this: Gates – software, Slim – telecom, Mittal – steel.

There are numerous academic papers which support both opinions. The most recent one I found regarding concentrated investments is by Ivkovic, Sialm, and Weisbenner,  “Portfolio Concentration and the Performance of Individual Investors” (2008) which concluded:

 “A particularly compelling result is that the trades made by concentrated households outperform the trades made by diversified households even after adjusting for household fixed effects, that is, after controlling for households’ average investment abilities. Moreover, we find that the performance of the trades made by households that become more concentrated improves, whereas that of the trades made by households that become less concentrated deteriorates.”

In favor of diversification, perhaps the most influential research paper came from Dr. Harry Markowitz (1959), who won the Nobel prize for his work in Modern Portfolio Theory (MPT). He concluded that diversification reduces risk only when assets are combined whose prices move inversely in relation to one another. I could fill volumes on the various theories that resulted from Markowitz’s work, but would rather give you an example of it’s application. In practice, Jack Meyer, head of the multi-billion dollar endowment fund at Harvard University says, “The benefits of diversification are indisputable. Diversification rules. It’s powerful and our portfolio is a good deal less risky than the S&P 500.”

At Alhambra, our founding principle is rooted in Modern Portfolio Theory. Almost daily, we deal with private clients who think they are diversified, but in reality they are not correctly diversified. Our model portfolios emphasize capital preservation and reducing volatility while generating attractive rates of return vis-à-vis, inflation. We run both strategic and tactical versions of our popular portfolios depending on our client’s preferences. The last three years have been challenging for investors, but truth be told, diversification worked perfectly despite converging correlations.

 

For more information on our model portfolios, please call your Alhambra representative or contact us at info@alhambrapartners.com.