The Problem with Diversification

In a previous article, we discussed the three different investor types: Savers, Speculators, and Specialists. If you recall, Savers are prone to diversifying their investments in such a way as to generate relatively small but consistent returns.

There are many people who believe the key to long-term financial freedom is to diversify and wait. Not only is this a common philosophy among the masses, but there are plenty of investing “gurus” who also push this investing style above all others.

In fact, just this morning, I came across the following excerpt in an article I was reading. It highlights the slow and steady path that Savers use to achieve long-term financial independence:

Sounds great, doesn't it? But, while it’s true that using the Saver style of investing will likely allow you to achieve financial freedom (after 35-45 years!), there is a major downside to this investing style. The downside is your returns rely on just a single variable: Time.

The longer you wait, the more money you have, but other than waiting, there is absolutely nothing you can do to influence the return on your investments. You have no control over how quickly you grow your money.

There are two main classes of people who would find this method of investing tremendously sub-optimal:

• Older investors: A lot of people don’t start planning for retirement until they are 35, 45, or even 55 years old, and they need to see equivalent net worth growth in much shorter periods of time than their 25 year-old counterparts who have 40 years to let their money compound;
• Wealth Creators: Those who seek financial independence in their youth (i.e., those who don’t feel like working and waiting for 40 years), will never achieve their goals using this method of investing.

But luckily for these two groups of folks, time doesn’t have to be the only factor when it comes to trying to achieve financial independence. When it comes to investing, there are actually two important variables that contribute to how much your money will grow. As we discussed, Time is the first. But the second is equally - if not more - important: Rate of Return.

Rate of Return

Again, if you read enough articles like the one above, you would think that the only rate of return you can get on your money is the 7-9% that you get from diversifying your money across lots of paper (stock market) assets. But, is it really the case that all your calculations should be based around the assumption that your investments will return 8%?

There are lots of investing strategies that return more or less than the much-quoted 7-9%. For example, savings accounts return around 2%, not enough to even keep up with inflation. Treasury Bills (T-Bills) and Certificates of Deposit (CDs) return about 5%.

Obviously, those investments return less than typical stock market returns – I’m guessing none of them are new to you. But what about those investing strategies that return more than the 7-9% you’ll get through stock diversification…do those exist?

Yes, and we’ll get to that in a minute…

What’s Does a Few % Really Mean

Before we talk about investments that return more than the standard diversified rate of 7-9%, let me address the question I often hear when having these sorts of discussions with my friends, “What’s the big deal whether I’m making 7% on my money or 15% on my money? There can’t be that big of a difference, can there?

Well, it’s just like in the example from the article where ten years can mean the difference between retirements and having to continue to work. A couple percent compounded rate of return can make the difference between being able to retire in 40 years vs. being able to retire in 10 years. For a lot of older investors - and younger investors who don’t care for work - this is the key.

Let’s look at the difference in the growth of your money based on different returns…

Using the example situation above, let’s assume an investment amount of $2000 per year. For a 25 year old who has 40 years to invest, we can expect somewhat more than $585,000 by the time he turns 65. Now, what if that 25 year old were to receive 15% annual return compounded for the same 40 years…how much do you think he’d have? The answer is, more than $5.3M! The difference between an 8% and a 15% return over 40 years was nearly five million dollars, or 6 times as much!

So, what about a 35 year-old who wants to have the same amount at 65 as the 25 year-old. If you recall, the 35 year-old with an 8% return would have about $250,000; but if you increase the annual return to 11.7%, the 35 year-old would have the same amount (over $585,000) when he turned 65 as the 25 year-old.

How about a 45 year-old that only had 20 years to save? To have the same amount as the 25 year-old when he turns 65, he’d need about a 20% return. So, if you can increase your average annual investing return from 8% to 20%, you can cut the amount of time necessary to reach your retirement goal (or any financial goal) in half!

The point being, when you only consider the Time variable of investing, you miss a key element that defines your success as an investor. And that’s Rate of Return.

Diversification vs. Specialization

So, now that you’re (hopefully) convinced that you’d much rather be making a higher rate of return than a lower one, let’s get back to the issue of how to make more than 7-9% on your money. Is 15% achievable? How about 20%? More?

Yes, they’re all achievable...and more. But, to achieve such high returns, you obviously must achieve better-than-average returns, which means you need to do more than just religously put your money in a diversified portfolio and forget about it. For everyone who makes less than the average 8% through passive diversification (and there are a lot of them), there is someone who is making more than 8%. And those who take the time to really learn how to invest in their desired investment vehicle can make a lot more than the average return.

To be one of those people, you need to become an expert in your area of investing. Whether that’s the stock market, building businesses, real estate, collecting antiques, or something else, you need to be a whole lot better than the average investor in that area. And, if you are, you will see superior returns. There are stock market investors who make 30%, 50%, and even 200% yearly returns on a consistent basis; there are business men (think Warren Buffet) who find a strategy for building/buying businesses and make huge returns on their investments year-over-year. And so forth for every type of investing.

But to achieve these levels of return requires focus, education, and experience; you must become an expert in your investment area. Sometimes it can take years. But that’s why the best investors are highly focused on one area of investing, as opposed to diversifying. They become great at what they do, and because they are so good at what they do, their returns far exceed the average, and far exceed what they would get if they were to just passively diversify their investments.

If you recall our article on The Three Types of Investors, you’ll see that the type if investor I’m referring to here is a Specialist. By Specializing, you have the ability to achieve wealth much more quickly than by simply saving.

In fact, the majority of the wealthy people in the world have earned their wealth by being Specialists. And you can too.