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014 - Increase Your Chances of Survival: Diversification, Part 1

014 - Increase Your Chances of Survival: Diversification, Part 1

Episode 014: Diversification (Part 1) — Survivability and Optionality

Synopsis

In Episode 014, Jared breaks down the most misunderstood concept in finance: Diversification. Moving past the tired "eggs in one basket" cliché, Jared explores diversification as a tool for managing uncertainty and avoiding "Game Over" scenarios in your life portfolio. You will learn the mechanical difference between Company-Specific Risk and Systematic Risk, the danger of "Diworsification," and why the ultimate goal is a strategic blend of diversification (for survivability) and concentration (for acceleration). From Wisconsin winter "grumpy trudges" to the 2008 mortgage crisis, this episode provides a blunt, fact-focused audit of how to spread your resources without spreading yourself too thin.

Detailed Sequential Outline

I. The "Grumpy Trudge" and Relative Volatility

  • (0:46) Wisconsin Winter Walks: Jared uses his family’s "grumpy trudges" through the snow as a literal example of relative volatility.
  • (2:38) Alecia as the Stable Asset: In a family of five, someone is always having a terrible time, but it’s rarely the same person—except for Alicia, who is the "stable asset" in a volatile portfolio. Her stability enhances the "returns" of the walk.
  • (4:19) Diversification Defined: Most simply, it is spreading investment resources across multiple items to manage an uncertain future.

II. Deconstructing the "Eggs in a Basket" Cliché

  • (4:38) A Flawed Analogy: Jared deconstructs the common "eggs in one basket" phrase, noting that in reality, we only use two baskets when the eggs don't fit in one.
  • (6:04) Uncertainty vs. Conviction: We diversify because outcomes are probabilistic, not guaranteed. If we were 100% certain, we would go "all in". Diversification is a tool for the 99% of the time we aren't certain.
  • (8:52) Humility and Optionality: Diversification isn't about fear; it's a mature response to the fact that we do not fully control outcomes. It is an act of humility.

III. Risk vs. Volatility

  • (10:14) Defining Real Risk: Real risk is not volatility (temporary ups and downs); it is the likelihood of a "permanent loss of capital" or going to zero.
  • (10:57) Company-Specific Risk: Risks unique to one entity, such as fraud, product failure, or the death of a "Key Man" CEO.
  • (11:57) Systematic (Market) Risk: External factors like inflation, recessions, or war that affect every "asset" regardless of individual quality.

IV. The Math of Spreading Risk

  • (13:16) Reducing the Odds: Adding a second holding cuts company-specific risk by 50%.
  • (14:06) The 90% Threshold: Holding 10 equally allocated items eliminates approximately 90% of specific risk.
  • (7:35) The aggregate portfolio: While individual companies are uncertain, a well-diversified portfolio allows for high certainty in the aggregate long-term trajectory.

V. "Diworsification" and the Terrible Pie

  • (14:07) Adding Garbage: Diversification is not a "hall pass" to do stupid things. Adding "crap" to a recipe just taints the entire dish.
  • (15:36) Peter Lynch's Term: "Diworsification" occurs when you add low-quality assets just for the sake of having more items, which increases complexity without improving returns.

VI. Multiple Ways to Be Right

  • (16:13) Different Drivers of Return: Proper diversification uses assets that respond differently to the same economic conditions.
  • (17:22) Failure Modes: Ideally, a crisis for one company (e.g., high oil prices) is an opportunity for another in the same portfolio.

VII. Survivability: Avoiding the "Zero"

  • (18:28) The First Rule: Be invested and stay invested. Do not interrupt compounding.
  • (18:40) Game-Over Scenarios: Highly leveraged, over-concentrated bets are the primary cause of "zeroing out."
  • (20:57) Time to Recover: Younger investors can take more concentration risk because they have more "unknown time" to recover from a dip. Diversification becomes more mandatory as you age and have less time to bounce back.

VIII. Diversification Pitfalls: Pokemon and Mortgages

  • (25:26) Speculative Bets: Jared slams the idea that Pokemon cards are valid diversification; they are often just bets on speculative supply and demand with no fundamental value driver.
  • (27:17) The 2008 Lesson: Bundling thousands of "garbage" mortgages together didn't make them "AAA" quality. Bundled crap is still crap. Diversification cannot save poor underwriting or overpaying.

IX. Application to Life: Friends, Marriage, and Hobbies

  • (31:30) The Friend Group Fallacy: Having dozens of bad friends isn't "better" than having one; it’s just more influential in the wrong direction.
  • (33:03) Marriage Concentration: Marriage is an area where you want zero diversification. Exclusivity and concentration protect the asset from going to zero.
  • (33:37) Risk-Heavy Hobbies: Adding "base jumping" to an accountant’s life isn't diversifying; he’s just increasing the probability of a "Game Over" event without a real expectation of reward.

X. The Concentration/Diversification Trade-off

  • (36:44) Wealth Creation vs. Maintenance: Concentration is how you get rich; diversification is how you stay rich.
  • (38:45) Speed vs. Safety: Concentration (the engine) provides acceleration, while diversification (the seatbelt/airbags) provides survivability.
  • (39:39) The Average Trap: Too much diversification (e.g., moving from 40 holdings to 80) guarantees average results and makes it impossible to beat the market.

XI. Gym Parables: The Bench Press vs. The 1-Rep Man

  • (40:45) Over-Concentration: The guy who only does bench press has an impressive chest but "legs like twigs." He is physically fragile.
  • (41:54) Over-Diversification: The person who performs one rep on every single machine in the gym. They are "busy" for two hours but achieve zero strength stimulus because the reps aren't effective.

XII. Conclusion: The Holy Grail

  • (44:52) Blending the Tools: Success requires using both tools. Diversification = Survivability + Optionality. Concentration = Acceleration + Risk.
  • (46:05) The Triple Threat: If you can achieve survivability, optionality, and acceleration simultaneously, you have found the Holy Grail of investing.

Quotes to Remember

"Diversification is not a magic spell. It is not a hall pass to buy or do stupid things."
"Real risk has very little to do with volatility—temporary ups and downs. Real risk has everything to do with how likely something is to go to zero."
"Bundled crap is still crap. A portfolio of garbage does not smell better just because it was bundled together with a bunch of other garbage."
"Concentration is how you get rich, and diversification is how you stay rich."
"Diversification is survivability and optionality. Concentration is acceleration and risk. Blending them correctly is the Holy Grail of investing."

Next Episode: Diversification Part 2: Applying these concepts to your career, your mindset, and the "investing macros" of time and energy.

Full Timestamped Transcript

014 - Diversification Part 1

(0:14 - 0:45)

Good day, investors. Welcome to vested. I am your host, Jared Bowers, and as we continue our trudge through portfolio management concepts and practices and apply those to both money and to life, we get to dive into a fun one today.

 

(0:46 - 1:06)

And I said trudge through portfolio management because a specific example in my life comes to mind when I use that word, trudge. That's what my family has affectionately come to call our winter walks through nature here in the great state of Wisconsin. More specifically, we call it our grumpy trudge.

 

(1:07 - 1:22)

We like to occasionally take walks in the forest in the winter wonderland that is in our area. It's not currently winter as I'm recording this, but don't worry, considering where we live, it soon will be. Winter is never too far away.

 

(1:23 - 1:35)

And when I say that we like to take these walks, I don't mean the five of us here in my immediate family. I mean my wife, Alicia. She likes to take these walks.

And on these walks, invariably, one of the five of us is just ticked off about life, having a terrible time with an awful attitude. No one knows why. It just happens.

Every. Single. Time.

And that person is not the same person every time. It switches around. That attitude usually lasts the entire time of that walk.

That trudge. That person has been me at times, admittedly. That person has never been Alicia.

 

(2:11 - 2:27)

So because of that, our family has come to calling these walks through nature our grumpy trudge. Because someone is always just really, really angry, pissed off at life. And to make it even better, there's usually several inches of snow to trudge through.

And we lose people sometimes. By people, I mean family members. We always find them, at least we have each time so far.

So what does this have to do with our topic today, which is diversification? Well, we have a well-diversified family when it comes to who's ticked off. It's not always the same person who's down. If it was the same person, that would be bad.

 

(2:54 - 3:09)

Or maybe that would make it easier. If it was the same one of us each time, they would have been sold from the family portfolio a long time ago, either through adoption or abandonment or by other means. But I'm thankful that there are five of us.

And therefore, we have pretty good diversification when it comes to our attitudes. Except for Alicia. She's not volatile or unstable enough to ever be the one who's ticked off.

 

(3:22 - 3:28)

Boring. But that is a good thing. That's actually an example of diversification as well.

 

(3:29 - 3:44)

She is a stable asset in an otherwise volatile portfolio. And that can and will enhance returns over time. And when she hears that I have described her as a stable asset, man, she is going to be so happy.

 

(3:45 - 3:56)

But her being my editor, I'm seeing in the notes that she also noticed that I called her boring. But I said trudge, and that's what comes to mind. And I think it's on topic for today.

 

(3:57 - 4:19)

We are going to talk about what diversification is, but we are also going to spend quite a time in this episode talking about what diversification is not. Because there are a lot of misconceptions and incorrect understandings, misapplications of diversification. What diversification is, most simply, is spreading your investment resources across multiple different items.

 

(4:20 - 4:37)

You've probably heard it described before as not having all your eggs in one basket. I think that's an okay summary of diversification. For some reason, every time the topic of diversification comes up, that simple and kind of hokey analogy about eggs in a basket also comes up.

 

(4:38 - 4:49)

I'd like to know how many of you listening have ever put eggs in a basket. Probably not many. And if you did, you probably didn't think much about the fact that they were all in one basket.

 

(4:50 - 5:07)

The only reason you'd ever use more than one basket is because all the eggs wouldn't fit in just one. Aha! We know the phrase, but we don't even follow it. And why? Because in the case of actual eggs in an actual basket, it's not really necessary.

 

(5:08 - 5:25)

Just be careful when you're carrying it. And if you took the time to put half of them into a different basket, you'd either waste your time making two trips, or you'd increase your risk of dropping them because now you have two baskets to carry. I'm starting to see that I might feel too strongly about this.

 

(5:26 - 5:38)

And I probably just ruined this phrase for you. But there is a point to this minor rant about baskets and eggs. Most have a simplistic or misapplied understanding of what diversification is.

 

(5:39 - 5:48)

And I think that is encapsulated in that phrase. Don't put all your eggs in one basket. Yes, in the sense that it's technically true.

 

(5:48 - 6:03)

But no, in the sense that it's not quite that simple. Diversification is more than just having multiple things. Because for what purpose do we use diversification? Well, the future is uncertain.

 

(6:04 - 6:09)

Outcomes are not guaranteed. They're probabilistic. And risk exists.

 

(6:10 - 6:20)

Upside and downside are real possibilities with most things we invest in. And so we diversify. We spread out our resources.

 

(6:20 - 6:35)

Because if we were completely certain about something, we wouldn't need to diversify. We could just go all in on that one certain thing. And there are times in life where we should see clearly enough and we are confident enough that we can go all in.

 

(6:35 - 6:56)

That we should go all in. Whether that's just a rare, uncommon opportunity, or whether that's a gut feeling, or whether that's the identification through years of practice and expertise that is built, we will come across opportunities in life that we believe the right thing to do is to go all in. And in those cases, it doesn't feel like an undue risk.

 

(6:57 - 7:09)

This doesn't just happen in business or in investing with money. But we may also have that with marriage, with starting a family. And time will tell if that's the case, that it's not an undue risk.

 

(7:10 - 7:34)

Actually, the returns of the investments you do or do not make will tell if that's the case. And I have to say, even with as much time and effort as I put into managing my portfolios of money, investments for myself and my clients, I am not certain when it comes to each of those investments. Admittedly, I'm not 100% certain about any of the companies that I invest in.

 

(7:35 - 8:01)

But because of diversification, I've built a portfolio that I am quite certain about in aggregate terms, of its long-term future, its long-term potential, where it's going to be, its trajectory. That's teasing a little bit about what can be achieved through diversification, and so we're going to dig into that. Diversification is often discussed as some sort of spell that can magically make something safer or better.

 

(8:02 - 8:19)

Not to worry, we're diversified! But diversification is not a magic spell. It's also not something that you can just claim, like saying it makes it true. It is a tool that needs to be used and implemented correctly to get the results that we're looking for.

 

(8:20 - 8:38)

And just like every other tool that we've talked about and will talk about, it can be used correctly or incorrectly. It can be used for positive effect in your portfolios or for negative effect. Even though we apply diversification because of uncertainty, that does not mean that it's about fear or lacking conviction.

 

(8:38 - 8:51)

You could go all-in on one thing. Another investor said, The more you know and the more confident you are, the less you diversify. Knowledge and confidence are great, but they do not eliminate risk.

 

(8:52 - 9:03)

And they also do not eliminate uncertainty. So diversification is not about pessimism or fear. It's ultimately about humility and optionality.

 

(9:04 - 9:16)

We have to admit that we do not know the future and we do not fully control outcomes. That's hard for many of us to admit, including me. I want to believe that I have control over certain things.

 

(9:17 - 9:41)

But the two things that we do have control over are what we are exposed to and what our concentration is. And those two things, what we apply our investment resources to and how concentrated we are in them, are the most important things underlying the concept and practice of diversification. You may already be familiar with how diversification can and would be applied in financial investing.

 

(9:42 - 9:57)

That is where this practice of diversification is most commonly applied, with financial portfolios. At least that's where we think of it as being applied most often. In money investing, diversification exists because the future is uncertain.

 

(9:58 - 10:13)

And even great businesses, sound and safe investments can and likely will experience volatility or distress at times. Temporary drawdowns are normal. It's also normal for good and strong businesses to take a turn for the worse and not recover.

 

(10:14 - 10:20)

Markets cycle in and out, up and down. Dips happen. And dips shouldn't affect us much.

 

(10:21 - 10:33)

It's permanent losses that we are working to prevent. We'll talk in more detail about risk specifically and what that is in the near future. As a teaser, risk has very little to do with volatility.

 

(10:34 - 10:44)

The temporary ups and downs. Which is how risk is traditionally and most commonly measured. Risk has everything to do with how likely something is to go to zero.

 

(10:45 - 10:56)

Permanent losses. And that is where diversification comes in. Diversification properly done spreads out risk, but it does not eliminate risk entirely.

 

(10:57 - 11:15)

In financial investing, we differentiate company-specific risk from overall market risk or systematic risk. In any company you invest in, there is risk that is specific only to that company. Let's say that a company you own commits fraud or has a terrible management team in place.

 

(11:16 - 11:32)

Or they have a product failure. Or another industry emerges that makes that product and business completely obsolete. They might have a great manager, an uncommonly amazing CEO, that falls ill or dies and is not able to manage the company in such an excellent way.

 

(11:32 - 11:56)

All of these things can impact and will impact the company very negatively from a value standpoint, right? These examples describe company-specific risk. But even great companies, without these company-specific bad scenarios happening, are still exposed to overall systematic or market risk. Things like recessions, inflation, interest rates, war.

 

(11:57 - 12:16)

The companies themselves can be doing exactly all the right things, minimizing all the risks that they can, no individual hiccups specifically to them, but can still be derailed by overall market factors. Factors that are completely outside of their control. Inflation goes up, and then interest rates go up again.

 

(12:16 - 12:22)

That's an affordability issue. People buy less of their products or service as a result. Recession happens.

 

(12:23 - 12:31)

Maybe a pandemic happens and spikes fear. People stay home. Swift and rapid contraction in spending in that case.

 

(12:32 - 12:43)

Fewer of their products or services sold. Risk. Remember, diversification does not completely eliminate risk, but it does, when applied correctly, reduce risk.

 

(12:44 - 13:16)

And you've probably already guessed that diversification mostly reduces the risk in the company-specific category. It can help us manage that second category of market or systematic risk, but spreading out our investments is mostly about reducing company-specific risk. So continuing on the money investing side of things, how do you diversify in practice? If you hold one company, you are exposed to all of the company-specific risk of that one company plus all of the market or systematic risk.

 

(13:17 - 13:44)

So if you add just one more company to your portfolio, you are already going to see big benefits from diversification. You have diversified fully half of your company-specific risk just by adding a second holding and splitting your money between two of them. Because it's unlikely that both of those companies would have their product fail or their CEO die or have too much overlap in company-specific problems that could arise in the same period of time.

 

(13:44 - 14:06)

And if you have 10 holdings, if you equally allocate your money between all 10 of those, you've probably eliminated your company-specific risk by close to 90%. But diversification, even if done very well, does not guarantee positive returns. Diversification also does not protect us from stupidity.

 

(14:07 - 14:28)

As an aside, I often hear the excuse from people who want to buy something speculative, in other words, place a bet with their money, that they're buying it in the name of diversification. As though just adding another ingredient is somehow going to make the recipe better because it's another ingredient. And no, that is not how diversification works.

 

(14:29 - 14:52)

Just adding ingredients that don't belong or are actual garbage does not make the overall portfolio of ingredients better. And claiming diversification in that case is a misapplication of the concept. Adding crap, literally, adding poop to a recipe, a food, does not make it better and does not give you a pass just because it's one of dozens of ingredients.

 

(14:53 - 15:04)

All you did was add crap to a recipe, and it taints the entire thing. It is still the terrible, awful pie. So diversification is not a hall pass to buy or do stupid things.

 

(15:05 - 15:36)

If your portfolio is made up of bets rather than investments, no matter how many you have, that is not diversification. And if your diversified portfolio can still be wrecked by one headline, one scandal, one industry crackdown, that's also probably not diversification. And along the lines of adding something that's just bad to a portfolio and calling it diversification, that has been described as diversification, coined by legendary investor Peter Lynch.

 

(15:37 - 15:54)

That should be a term we all keep in mind when we hear about someone adding something that is garbage to a portfolio in the name of diversification. Now let's talk more about what diversification is and how it actually works in application. And let's keep doing it with financial investing.

 

(15:55 - 16:12)

That is where it's most commonly applied, maybe not where it's most interestingly applied. We will talk about diversification applied to life, don't worry. But in financial investing, diversification spreads your money across different assets with different drivers of return that ideally do not all move together at the same time.

 

(16:13 - 16:22)

It is built on the concept that there is more than one way to be right. There are likely multiple ways of being right. Many roads to roam, so to speak.

 

(16:22 - 16:35)

There are many avenues to getting similar returns. There's not just one best way to put together a collection of holdings. You may read that some of the best performing investment funds last year returned, let's say, 40%.

 

(16:36 - 16:52)

And there were probably multiple funds that achieved that. But digging into the holdings within each of those funds, you will probably find that there is not much overlap between the holdings of those funds. They probably do have some percentage of their portfolio invested in the same companies.

 

(16:53 - 17:03)

But most of them aren't the same companies. Yet they achieved a similar magnitude of returns. That's what I mean when I say that there are multiple ways of being right.

 

(17:04 - 17:20)

And those diversified portfolios have a mix of assets that respond differently to different economic conditions. The holdings have different risk profiles, which means that they aren't all exposed to the same markets or the same risks, the same drivers of return. And they have different failure modes.

 

(17:22 - 17:37)

A crisis for one company might be an opportunity for another. And you may own both of those companies. A commodity crisis, for instance, let's say oil prices skyrocketing, might be devastating to one company, but might present a great opportunity for another.

 

(17:38 - 17:58)

And if you own both of those companies, voila, diversification. And ideally, in that case, the upside offsets the downside. And because of the asymmetric return profile of the market, what you are risking versus what you have the opportunity to earn, oftentimes the upside does offset the downside if you're properly diversified over time.

 

(18:00 - 18:13)

Balancing upside and downside risk is part of how I evaluate whether a portfolio is diversified. I want it to be diverse by driver of returns, what can make it win. I want it to be diverse by downside risk, what can break it.

 

(18:14 - 18:27)

And I want it to be diverse by time. When does it pay off? Or what part of the market cycle is it exposed to? Now let's talk about survivability. This is one of the most important points of diversification.

 

(18:28 - 18:40)

I often tell my clients and those that I help with their money that the first rule of investing is to be invested and stay invested. Do not interrupt compounding. We must stay in the game, so to speak.

 

(18:40 - 19:00)

We also have to avoid game over scenarios where we can go to zero or where we are forced to pull out of the market. This most commonly happens with two scenarios. Being too leveraged, meaning you have too much debt and not enough equity, and also being too concentrated, not enough diversification.

 

(19:01 - 19:20)

And if you put those two things together, a highly leveraged single bet, for instance, there is potential for high returns, but there's also potential for going to zero. And if it's highly levered, even going below zero. And if that happens, there are no more returns to be had.

 

(19:21 - 19:34)

Zero literally zeroes things out. We understand avoiding game over scenarios in a lot of areas of our life. This is why we wear seatbelts, why we lock our doors at night, why we go to the doctor for checkups.

 

(19:35 - 20:03)

All of those things are focused on managing outcomes that on a day-to-day and probably even year-to-year basis are relatively low probability outcomes. A fatal car accident, a home invasion, a terminal illness that could have been found early but was missed, all of those are examples where we are trying to avoid a game over situation. And diversification is a powerful tool to increase our probability of staying in the game and avoiding a big ol' zero.

 

(20:04 - 20:12)

Because drawdowns and dips are recoverable. And many times they present opportunities. But zeroes are pretty tough to recover from.

 

(20:13 - 20:36)

You can't reallocate and take advantage of a dip if there's nothing there to reallocate. Investing in a single company, no matter how strong that company is, has a much higher probability of hitting zero than a portfolio of even just two or three companies. We want to set up our portfolios so that even in a big drawdown scenario, we live to invest another day.

 

(20:37 - 20:57)

Speaking of living another day, this is especially true the younger we are, the earlier we invest, and the more time we have to recover from situations. We are able to take on more risk the more time we have to recover from it. This is why diversification becomes even more important as we get older.

 

(20:57 - 21:10)

Because we have less time to bounce back. And this is also why older folks often have more diversified and less volatile portfolios than younger people. The same can be said for the lives that we live overall.

 

(21:11 - 21:20)

Older people tend to have more diversified and less volatile lives than younger people do. We want to hold on to what we've built. We want to protect it.

 

(21:21 - 21:34)

But that doesn't mean that diversification is a reaction to fear. It is a mature response to uncertainty. Diversification is a crucial and powerful tool to use correctly in order to keep the compounding going.

 

(21:35 - 21:45)

And keep in mind, the right thing to do might be to go all in. But make sure you've fully evaluated it and you're comfortable with the risk. More on that soon.

 

(21:46 - 22:00)

So before we move on, just a question to consider. Is there an area of your life, financial or otherwise, that could take you to zero? Because of overconcentration. Because of a lack of assessing the risks.

 

(22:01 - 22:14)

We should consider, we all should consider, where we are fragile to loss. Especially where we're fragile to big losses. Alright, enough on what diversification is.

 

(22:14 - 22:28)

Let's talk more about what it is not. We've talked about how diversification is not a magic dust that you can sprinkle or a spell that you can cast on a portfolio and make it safe. Claiming diversification doesn't mean anything.

 

(22:28 - 22:45)

Even if it is adding more holdings. We now know that adding garbage to an otherwise clean portfolio does not make it better just because it's another holding. Related to that, diversification is also not just owning or investing in lots of random things.

 

(22:46 - 22:54)

Technically, you will achieve some amount of diversification with that approach. But diversification should be for a purpose. It should be intentional.

 

(22:55 - 23:10)

It is not just owning a bunch of stuff. Diversification should also not be seen as buying or owning everything. A person who owns a tiny piece of every single thing that can be owned could be referred to as being fully diversified.

 

(23:10 - 23:22)

And you can pretty easily do that with investing. You can buy an index fund for every major index in the US and around the world. This will allow you to own a little bit of everything.

 

(23:23 - 23:37)

But I think that there are better ways. I don't think owning everything is the point of diversification. Owning everything can be okay from a financial investing standpoint because average results in the market are still pretty darn good.

 

(23:38 - 23:51)

But let's consider what being over-diversified means in other areas of life. Usually what that means is spreading yourself too thin to the point that you can't really get returns from the things that you're investing in. More on that in a bit.

 

(23:52 - 24:07)

Diversification is also not permission to do stupid things. We mentioned that before. If a portfolio is mostly a collection of rational investments, someone might argue that the diversified portfolio gives you the option, permission, to make a few stupid bets.

 

(24:08 - 24:29)

While true that the diversified portfolio will protect you from the possible downside of those bets to some extent, taking that approach makes the overall portfolio worse, not better. An appropriate approach to diversification is everything you add to it is an overall enhancer. Not that the good is there to protect you from the bad.

 

(24:30 - 24:44)

That's an important distinction to make. Another thing that diversification is not, or it shouldn't be, is an excuse for low conviction. An excuse for not having an opinion or an understanding of what you're investing in.

 

(24:45 - 25:11)

There's a tendency to make up for not knowing with just adding more and investing in more things. But that usually creates complexity and messiness. There's a lot to be said for trying different things, owning a lot of different things, but a portfolio of money or a portfolio of other things that just keeps adding more stuff without purpose, without direction, is just turning up the knob of chaos and turning up the likelihood of mediocre returns.

 

(25:12 - 25:25)

Diversification is not simply just owning more things. It is owning different things on purpose. An example that comes to mind from somewhat recently is a resurgence from many decades ago.

 

(25:26 - 25:36)

Pokemon cards. And when I heard about that, I thought, really? Pokemon cards again? Huh. Yeah, Pokemon cards are having a resurgence.

 

(25:37 - 25:50)

With some people not just collecting them, but investing in them. And I definitely put investing in quotation marks. There are people out there who are thinking that they are diversifying their portfolio by adding Pokemon cards.

 

(25:51 - 26:09)

And just to be clear, they are buying them with the hope, with the expectation, that some of them will go up in value. Whether these people just have a portfolio of Pokemon cards or whether they are adding them to an otherwise legitimate portfolio, this is an example of adding garbage. And it is not improving diversification.

 

(26:10 - 26:29)

This is a good example of diversification. Adding something like Pokemon cards to an otherwise strong and healthy portfolio does not make it better. Another wrong application in this context would be, I am going to buy more Pokemon cards because that will spread out my risk compared to just having a few.

 

(26:30 - 26:45)

But what they did in that case was the opposite. They concentrated their risk in that case by having more of the same speculative thing that has no fundamental value behind it. No real driver of returns except speculative supply and demand, making bets.

 

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With prices based on other people making bets. I have nothing against Pokemon cards. I have everything against the idea that they are an investment that can add to or enhance the diversification of a portfolio.

 

(27:02 - 27:16)

That is not where you should be putting your investment resources. Let's look at another example where adding more things to a portfolio does not make bad things better. And this is a case that affected a lot of people a couple decades ago.

 

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You might be familiar with the mortgage bundling in the investment products that happened leading up to the 2008 financial crisis. Loan originators and investment companies took garbage mortgages, mortgages from people who bought way more house than they could ever afford, lent to them by very stupid banks and mortgage lenders. Those loans had high individual risk of default, of the borrower not paying their loan back.

 

(27:44 - 28:07)

But these mortgages were bundled together and packaged into loan products and then sold to investors and other banks and financial institutions. And the idea at the time was that since we're bundling these together, we're spreading out the risk. Take a bunch of risky loans individually, package them up and sell them to the public and other institutions as AAA rated debt securities.

 

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Meaning that they were rated as, scored as the highest quality with the highest credit rating that a loan or loan product could get by the debt rating agencies. The credit rating agencies at the time determined that these bundled loans were very likely to not default. They were a very safe investment.

 

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That's what that meant. At least that's what people thought it meant. This was a perfect example of bundling crap together does not make it not crap.

 

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Or said not as a double negative, bundled crap is still crap. And unfortunately, the purchasers of those bonds, those bundled mortgages and the adjacent products that were connected to them, and then ultimately the entire economy experienced that reality. And it was pretty bad.

 

(28:58 - 29:19)

Because these bundled mortgages, because they were rated AAA, the safest rating possible, they were heavily leveraged with debt and sold as more flavorful investment products. Banks that had these on their balance sheet borrowed heavily against them to make more loans, believing that they were strong and stable assets. They did not do their own analysis.

 

(29:20 - 29:33)

They just took someone else's word for it. And we've talked a bit about debt before, about what a powerful tool it is, and that its primary function is as a magnifier. It's great to magnify returns when they're positive.

 

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Not so great to magnify returns when they're negative. And that is exactly what happened. And the entire global economy experienced the fallout of that farce.

 

(29:43 - 29:52)

It had ripple effects across the entire global economy for years. It hurt real people for a long time. Some never recovered.

 

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Everyone, and I do mean everyone, experienced a drop in wealth for a time. Whether that was from retirement assets falling, job loss, home values falling, which pretty much every one of them did, company failures, you would be hard-pressed to find someone who did not experience loss during that time. All because certain people thought that they could generate something fundamentally strong with fundamentally weak ingredients.

 

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And they convinced enough people of it. Diversification cannot save poor underwriting, poor risk management, speculation, or overpaying. Diversification does not turn bad investments into good ones.

 

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A portfolio of garbage does not smell better just because it was bundled together with a bunch of other garbage. Remember what I said just a bit ago. Avoiding zeros is probably the biggest reason to diversify and the most powerful benefit we get from it.

 

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Adding assets to a portfolio that have a high probability of going to zero does the opposite of what diversification is meant to do. And that is why claiming I'm diversified as though it's going to solve for poor selection and somehow generate better returns doesn't fly. You cannot generate a good recipe with bad ingredients.

 

(31:16 - 31:30)

You cannot create good outputs with bad inputs. Let's look at other examples as applied to real life. Specifically, I want to talk through situations where adding in the name of diversification does not make something better.

 

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Because I want to fully dispel the myth that diversification adding more is always a good thing. Especially when adding more is adding more of the wrong things. As parents, we care about who our kids' friends are, right? We are concerned that our kids don't pick bad friends who influence them in a bad direction.

 

(31:53 - 32:19)

As our kids get older, their friends have more influence over them than we do as parents. That's why, if we can put them into situations, into groups, into schools, where they're more likely to be surrounded by the kids who are pointed in a good direction versus kids who are bent on doing wrong, we should do everything we can to do exactly that. Their environment impacts their friend group to a huge extent.

 

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It's a big deal. So let me ask you this question. Which one is worse? Having one bad friend that they spend a lot of time with who influences them negatively or having dozens of bad friends who all influence them negatively? Oh, but it's better! Because now they're diversified.

 

(32:38 - 32:47)

They don't just have one bad friend. We can see through that fallacy pretty easily. Diversification is not better just because you are adding more components.

 

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Technically, their friend group is more diversified, yet it is worse, which means that it has undermined the entire point of diversification. What is it meant to do? Avoid zeros. Create optionality.

 

(33:03 - 33:21)

Let's look at this in the context of an example of marriage where diversification is not better. This is diversification from a different angle. In marriage, you want exclusivity, maximum concentration of soul partners, maximum concentration of sexual partners.

 

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Partner. Let's remove the S. Adding partners in the name of diversification just makes it more likely that the key asset that is meant to be protected goes to zero. Another example where adding to a portfolio does not make it better.

 

(33:37 - 33:56)

Let's look at hobbies from the standpoint of risk that is introduced into our lives. Let's say a desk worker, our favorite desk worker, who's already made an appearance a few times, our noble accountant. Let's say that Mr. Accountant has decided that his life is too vanilla, too boring.

 

(33:57 - 34:11)

And so he can add a hobby, an ingredient, that spices things up. But let's say that he decides to take up base jumping as a hobby. Definitely more diversified, right? Definitely changes the flavor of the portfolio.

 

(34:12 - 34:20)

Adding excitement, adding spice to life. But diversification in that case does not make the portfolio better. It just makes it riskier.

 

(34:21 - 34:36)

It increases the probability of going to zero. Again, just adding things to a portfolio does not make it better. If what you are adding is bad or just represents risk without the real expectation of reward, that's not diversification.

 

(34:37 - 34:50)

Now taking things back to the money side for a bit, we can talk briefly about the types of diversification we can apply to money. There's asset class diversification. And remember, there are only two fundamental asset classes.

 

(34:51 - 35:01)

Equity and debt. Ownership or lending your money out. Every investment product or fund or opportunity is a derivative of one or both of those two things.

 

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Equity or debt. They can be different flavors, different mixes, different risk profiles. But ultimately, you can own something or you can lend your money out.

 

(35:10 - 35:20)

Another layer deeper would be looking at your exposure to things like public equity versus private equity. Public debt versus private debt. Real estate.

 

(35:20 - 35:38)

In some cases, cash can actually add diversification to a portfolio if it is for a specific purpose. There are things like commodities, which are things like grains, oil, metals. Another layer deeper as you continue on the path of different things you can invest in would be goods versus services.

 

(35:38 - 35:52)

Which sectors you're invested in. And then getting even more granular below sectors as industries. You can consider business cycles, geographies, growth versus value, regulatory environments, domestic companies, international companies.

 

(35:53 - 36:04)

You can factor in political risk. All of those are considerations in financial investing. Ultimately, you can diversify by what it is, where it is, what can help it, and what can break it.

 

(36:05 - 36:23)

And you can apply these same concepts to life. We've talked through some examples already. You can apply the same basic framework of diversification, what it is, where it is, what can help it, and what can break it to all sorts of other areas of life where we should consider our level of diversification.

 

(36:24 - 36:43)

Our friends, our hobbies, what we're pursuing, our streams of income, the skills that we're going after. But the important thing is considering what the appropriate level of diversification is for each of these areas. We'll get into that shortly, but first, let's talk about the trade-offs of diversification.

 

(36:44 - 37:05)

Someone once said, concentration is how you get rich, and diversification is how you stay rich. You can build incredible wealth in a diversified way, but it will probably happen slower than what can be achieved through concentration, or going all in. Focusing your investment resources, concentration, can help you get rich faster.

 

(37:06 - 37:18)

It can help you build something faster. But it can also result in going broke faster, losing it all. That is the inherent trade-off of diversification and concentration.

 

(37:19 - 37:26)

We want faster outcomes. At least most of us do. But we also want safety in most things.

 

(37:26 - 37:45)

And those two things are usually in conflict. You can build a lot of muscle slowly and safely over a long period of time, or you can blast steroids and build it really quickly and unsafely. In most areas of life that are worth investing in, there is a balance that needs to be achieved.

 

(37:46 - 38:06)

And sometimes the slow and safe and diversified way is the only right way of doing it. Like with building muscle, in my opinion. We need to consider what the risks are, what the opportunities are, and what our willingness is to be exposed to concentration risk, and how long we are willing to take to get there.

 

(38:07 - 38:24)

Because diversification is an enhancer if done correctly. Not just a safety lever. Avoiding zeros by being diversified is a more sure way of making progress and getting to a goal if the alternative, concentration, has a high likelihood of going to zero.

 

(38:24 - 38:45)

And the lesson and application here is that we should have pockets and times and areas of concentration in our lives. But our spotlight of attention and focus and investment should not remain too concentrated in the same place or be positioned in a single narrow direction for too long. Maybe think of the example of a car.

 

(38:45 - 39:02)

Think of concentration as the engine, the accelerator, and diversification as most other things. Maybe the safety things, the seatbelt, the airbags, properly inflated tires with plenty of tread. Diversification in that case is an enhancer.

 

(39:03 - 39:22)

If you put all your resources into just building a bigger, faster engine, instead of all that safety and comfort stuff, you'd probably be able to get most places faster. But you'd also be really uncomfortable, really scared, and possibly really dead. It is possible to get there with concentration.

 

(39:23 - 39:38)

Just the engine and drivetrain and wheels. And yeah, you might get there faster, but it's probably a bad idea. But to go back to something we started talking about earlier, too much diversification is a great way to be average to below average in what we care about.

 

(39:39 - 39:54)

This applies directly back to my investment portfolios. If I double the number of holdings that I own, yes, technically, I am more diversified. But if I go from owning 40 companies to owning 80 companies, I am more likely to perform in line with the market.

 

(39:55 - 40:04)

Can I still beat the market? Maybe. Probably. There are investment funds that beat the market with 60, 70, 80 plus holdings.

 

(40:05 - 40:21)

But the more positions that I add, the closer to the market I will perform. Because the more you add to a portfolio, the closer to average you become. Now, as we look to start wrapping up this first episode on diversification, let's consider an example of over-diversification.

 

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Let's explore concentration and diversification within a positive pursuit that is not financial portfolios. Let's talk about the gym. This will fit nicely, coming off the heels of our episodes on putting in the reps.

 

(40:35 - 40:43)

If you thought I was done for a bit with gym examples, you thought wrong. I did not get it out of my system. It got more into my system.

 

(40:45 - 40:57)

We can all recognize the guy in the gym that only does bench press and not much else. The cutoff string or tank top that shows off the arms and probably a number of other things that we'd rather not see. Never more than 12 feet away from the bench press.

 

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Ready to chase anyone away that even looks like they might be trying to use his favorite bench. Probably wears his sweatband on his head, despite it being decades since he did any cardio. Legs like twigs, probably.

 

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But can bench 315 for reps. Impressive in that one domain. But clearly over-concentrated and in need of some diversification.

 

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Would probably get a lot of benefit from spreading his effort around. His investment resources in the gym. Maybe throw in a leg day every so often.

 

(41:32 - 41:46)

As offensive as that is to suggest. That over-concentration has resulted in some positive things. But unless he bench presses in competitions, most everyone can see that he'd be better off diversifying his approach a bit.

 

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Or a lot. Now let's look at an example of too much diversification. On the other extreme.

 

(41:54 - 42:12)

A positive pursuit of fitness, but consider the opposite of bench press guy. How many machines and exercise pieces of equipment are there in a typical commercial gym? At least dozens. Probably hundreds, right? If you include every type of bar, dumbbell, machine that you can do, there are a lot.

 

(42:13 - 42:25)

So consider that you have someone who does everything when they're in the gym. But just one or two reps of everything. They go to the dumbbells and they pick up a set of 20s and they do one shoulder raise.

 

(42:25 - 42:34)

Then they grab the 25s and they do one front raise. Then they grab the 30s and do one curl. They grab the 35s and do an upright row.

 

(42:34 - 42:41)

Then they grab the 40s and do one tricep skull crusher. They grab the 45s and do one overhead press. You get the idea.

 

(42:42 - 42:51)

They grab the 120s eventually and do a shrug. Kind of the only thing most of us can do with the 120s anyway. They run through the rack of dumbbells with that approach.

 

(42:52 - 43:24)

Then they go to the weight machines and they knock out one rep per machine. They hit every single piece of equipment and at the end of their workout, which probably took them a couple hours to do, so technically they worked out for two hours. They hit every single muscle group multiple times, hundreds of reps, probably tons of weight moved in aggregate, and what did they get out of it? Probably what they got was a high zone one to low zone two workout that burned some calories and kept their heart rate elevated.

 

(43:24 - 43:43)

If they moved along fast enough. Not a bad thing, but not anything that resembles a strength training workout that would provide a stimulus with enough effective reps to result in any intended outcome that they might want to get. They just used a lot of energy, burned a lot of calories, and spent a lot of time in the gym.

 

(43:44 - 44:10)

And if they're going to spend that much time, you'd assume that that person was going for some overarching goal of strength or muscle growth or a combination of the two. And some of the stats from that workout would be very impressive on paper. You moved how much weight? You did how many reps? You did a full body workout like five times over? You worked out for over two hours? That's pretty impressive.

 

(44:11 - 44:25)

You must be getting some great results. But no, all they did was spend a lot of time and make themselves tired. It accomplished even less than what the over-concentrated meathead at the bench press station did in 30 minutes.

 

(44:26 - 44:51)

He actually got some results from that. Again, diversification is not inherently a good thing, just like concentration by itself is not inherently a bad thing. And when either of those two are taken to an extreme, like we just talked through with the weightlifting examples in the gym, it should be clear to see how those can and likely will cause issues or not result in the outcome that you think that it should.

 

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Diversification and concentration are tools. They are not good or bad by themselves. It depends on how they are applied.

 

(45:00 - 45:08)

Sound familiar? I think this might be becoming a theme for us. It definitely is. Tools properly applied.

 

(45:09 - 45:19)

Diversification done well is survivability and optionality. Concentration is acceleration and risk. I'll say it again just to make sure that it's clear.

 

(45:20 - 45:35)

Diversification is survivability and optionality. Concentration is acceleration and risk. Those two things may seem like they're in conflict, but they can and should be blended together for the greatest effect.

 

(45:36 - 46:04)

And that is the skill we want to build, using both of them appropriately for the outcomes that we want. Because the appropriate mix of diversification and concentration in our portfolios of life can result in survivability, optionality, and acceleration while managing for risk. That would be powerful, right? We've probably just identified the holy grail of this investment theory and practice of diversification.

 

(46:05 - 46:20)

If you have survivability, optionality, and acceleration, you are probably going to be pretty successful in that area. And remember, like so much of what we talk about, these are tools. Let's learn how to use them and apply them well.

 

(46:21 - 46:42)

We are going to continue our exploration of this tool, actually more accurately, both of these tools of diversification and concentration, and we will apply them to many areas of life in the next episode. Thank you for investing in yourself and in those around you.

I will talk to you next time.

 

(46:56 - 47:06)

Diversified? Yeah, I'm diversified. I have over 80 types of crypto in my retirement account. What, you think I'd be dumb enough to have just a few?