Why Diversification is Not Always the Answer

April 16, 2019

The need to diversify is so foundational to financial advice that it can seem absurd to even question it. But sometimes clients question us in ways that have made us rethink the conventional wisdom regarding diversification in finance. Here’s what happened to me. Challenging the Cliché Advice It was sometime in mid-2009 when a colleague and I were meeting with a prospective client for the first time. He was part-owner of a ski resort in the Rocky Mountains as well as an investor in several rental properties. He explained how he had the opportunity to sell three years earlier (in 2006) and was advised to do so at the time by an advisor who told him he had too much of his wealth tied up in the business and that he needed to diversify. The client went on to explain that, had he done so, he not only would have missed out on double digit growth in his company over the subsequent years, but he would have lost millions by investing in a supposedly less risky, diversified portfolio of stocks and bonds just prior to the financial crisis of 2008/2009. It was a tough argument to refute. Yes, hindsight is 20/20. And, sure, I could have explained how 2008/2009 was a one-hundred-year flood scenario and that a financial crisis of that sort is unlikely to occur again in the near future. Still, he was making a deeper point that needs to be acknowledged. Concentrated Positions  For a certain subset of investors – more affluent, entrepreneurial people who are in growth mode and not planning to live off of their portfolio anytime soon – the best strategy may be to concentrate their investments. At Brown and Company, we’ve worked with a lot of business owners over the years, as well as quite a few real estate investors, and they tend to concentrate their wealth in these closely-held assets for a period of time. These clients often create wealth through a heavy concentration of time, money, and talent in business interest and real estate interests. The same is true of corporate executives whose asset base is often disproportionately tied to one company. That is not to say that diversification does not apply to these people or that mitigating the risks of these investments is not important. However, the fact remains that many high net worth clients have amassed their wealth this way. Stage of Life Matters The short way to say it is that wealth is often accumulated through concentration and preserved through diversification. Business owners and real estate investors in particular are much more comfortable taking risks in their own ventures because they understand the investments and – to a much greater extent than passive investments – have control over those investments. Think about what has to happen for someone to start a business in the first place. They need to overcome all of their instinctive fear and and desire for security to put it all on the line. They have to believe enough in their idea and ability to execute that they step out without a net. If they succeeded, it was (at least in part) because they were able to silence that “diversifying” voice in their head in order to place a big, risky bet on themselves. If you are a successful entrepreneur listening to an advisor lecture you about taking too much risk, you may have some understandable skepticism.  You may be thinking: “What do you know? By that same logic, I never would have taken the leap and been successful in the first place. I wouldn’t be here if I had listened to people like you.” Business owners are realists who learn by doing. They tend to be dismissive of those people who “know” things based on theories and concepts. No Cookie Cutter Solutions Rather than a one-size-fits-all approach, we believe it is much wiser to formulate advice based on life stage. If you are preparing to transition into retirement, you would benefit from shifting the focus from accumulating wealth to distributing wealth. That involves converting a largely illiquid asset base into a stream of income that will last for the next 30 years or more AND keep up with inflation. The implication is that there is a big change required in the way investment portfolio is constructed. The source of wealth can be the death of your wealth if you do not make adjustments based on changing priorities and circumstances. You can reach a point at which you no longer need to take the amount of risk you once did, but instead need to replace your income. In other words, “what got you here, won’t get you there.”

No strategy assures success or protects against loss. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.