At Exencial, we have long been believers in diversification as a tool for wealth maintenance. Although wealth is often obtained by focused work, such as owning and running a business, becoming an expert in a particular field or just hard work, we like to say that wealth is maintained by diversification.
The average life cycle of a publicly-traded company today is only about 10 years1, and that number has been decreasing. Even renowned companies once considered unstoppable encounter difficulties over time. One company that was in the original Dow Jones Industrial Average in 18962, General Electric, was recently removed from the index and its stock has plummeted in recent years. 3 Additionally, retail companies like Sears and JCPenney were thought to be staples of the American household not too long ago, but both companies are in serious trouble today.4
No matter how strong a company appears, chances are something will eventually disrupt its trajectory. For that reason, owning only five or six stocks is a risky way to maintain wealth. Diversifying aids in managing that risk.
Of course, diversified assets do not behave like the radio segment on A Prairie Home Companion about the children of Lake Wobegon who are all above average.5 Holding a diversified portfolio means that an investor is holding assets that, at least for a time, are doing well and some others that are underperforming. Rather than jettisoning the underperformers, we should first analyze why they are not generating expected returns. If there is something fundamentally flawed with the investment that could negatively impact future expected returns, it may make sense to sell the asset. But if the investment is going through a period in which it is out of favor, or one in which the market is more heavily discounting its value, we generally shouldn’t eliminate the position.
In fact, all other things being equal, out-of-favor assets that the market discounts more severely tend to see higher future expected returns. For example, the U.S. market was severely discounted relative to foreign markets during the Great Recession in the late 2000s.6 However, investors that remained in the market throughout that period were later rewarded with significantly higher returns over the next 10 years. 7
We see a similar thing happening with individual stocks within our Select Strategy. So far in 2019, many of the stocks in this portfolio that underperformed last year are outpacing the names that performed strongly in 2018. It is still early, but in some cases last year’s “laggards” may be turning into this year’s “leaders.”
In summary, mean reversion8 is an unavoidable force constantly at play in the market. What goes up (and down) often reverts closer to average returns. Companies and asset classes don’t continue to overperform or underperform indefinitely.
Being diversified means owning at least some investments that for a time underperform. This is the cost of obtaining diversification, a tool that is so helpful in maintaining wealth that has been created through focused effort and work.
Sources:
1. Fortune – This is how long your business will last, according to science
2. Yahoo! Finance – Dow Jones Industrial Average
3. CNN Business – General Electric gets booted from the Dow
4. Business Insider ¬– Sears has filed for bankruptcy and announced it would close more than 140 stores, but it isn’t the only department store that has struggled recently — here’s why
5. Podbean – A Prairie Home Companion: News from Lake Wobegon
6. Investopedia – The Great Recession
7. Yahoo! Finance – S&P 500
8. Investopedia – Mean reversion
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RETURNS. Information and opinions provided herein reflect the views of the author as of the publication date of this article. Such views and opinions are subject to change at any point and without notice. Some of the information provided herein was obtained from third-party sources believed to be reliable but such information is not guaranteed to be accurate. In addition, the links provided within are for convenience only and the provision of the links does not imply any sponsorship, endorsement, or approval of any of the content. We do not guarantee the content or its accuracy and completeness. The content is being provided for informational purposes only, and nothing within is, or is intended to constitute, investment, tax, or legal advice or a recommendation to buy or sell any types of securities or investments. The author has not taken into account the investment objectives, financial situation, or particular needs of any individual investor. Any forward-looking statements or forecasts are based on assumptions only, and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Any assumptions and projections displayed are estimates, hypothetical in nature, and meant to serve solely as a guideline. No investment decision should be made based solely on any information provided herein and the author is not responsible for the consequences of any decisions or actions taken as a result of information provided in this book. There is a risk of loss from an investment in securities, including the risk of total loss of principal, which an investor will need to be prepared to bear. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Exencial Wealth Advisors, LLC (“EWA”) is an investment adviser registered with the Securities & Exchange Commission (SEC). However, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. EWA may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Complete information about our services and fees is contained in our Form ADV Part 2A (Disclosure Brochure), a copy of which can be obtained at www.adviserinfo.sec.gov or by calling us at 888-478-1971
