Israelsen on Diversification (Part 1)

While I don’t always agree with his conclusions, I find Craig Israelsen to be a compelling contributor to Financial Planning magazine. In this blog post I address his February 2016 article “Why Not the Best?”

Israelsen writes:

     > Every good planner preaches the glory of diversification…
     > But here’s a reality that is less pleasant to disclose to
     > a client: a diversified portfolio will never be the best
     > performer in any given year…
     >
     > Comparing a broadly diversified portfolio with the
     > best performer of the year is complete nonsense, yet many
     > clients can’t resist doing it.
     >
     > History shows that the best performing investment in any
     > year will be the stock of a company that relatively few
     > people are actually invested in.

I have a couple problems with this last paragraph. First, he gives only two supporting examples. This hardly satisfies the claim that “history shows… in any year.” Two years is not every (“any”) year. Second, in order to be more rigorous he would have to define “relatively few.” Even a large cap stock, for example, has “relatively few investors” in relation to the total number of investors or certainly the total population.

From an anecdotal standpoint, I agree with this paragraph. I cannot count how many times I have heard people say “if only I had invested in XYZ” where XYZ, now significantly appreciated, traded in extremely low volume before the big run-up attracted fame and attention.

Israelsen writes:

     > …every year… the best performer is always a single
     > stock, never a stock mutual fund. A diversified group
     > of equities can never outperform the best-performing
     > single stock… for all practical purposes, the best
     > return is unachievable [italics mine]…

I wholeheartedly agree.

     > But here’s the rub: when we build a broadly
     > diversified portfolio, it will contain some asset
     > classes that do well in the current climate, and
     > some that will be underachievers. That is the real
     > challenge of diversifying: being patient as we watch
     > the various ingredients in our portfolio take their turn
     > being the hero—and the goat. If we’re not careful,
     > our emotions will lead us to chase the heroes… and
     > dump the goats.

Again from an anecdotal perspective, I completely agree.

I will continue with Israelsen’s article in the next post.