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Diversification = Worsification November 1, 2012

Posted by shaferfinancial in Uncategorized.
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As I started to question the assumptions I was being sold, I kept running into a mental block about how to diversify without using mutual funds and their huge variation issues. Finally, I ran into a couple of Warren Buffett quotes that enabled me to get through that block to see diversification for what it is. I then started to understand how the whole mutual fund industry had pulled the wool over my eyes. The actual theory of diversification is really about asset diversification and is for institutional investors who have large sums of money to invest for long time periods measured in decades. But what the mutual fund industry had successfully done was create an investing paradigm that was clearly insane. Owning large amounts of different company’s stock sounds good on the surface as does the average returns the market has given over 30-50 years. But, these mutual funds became so big they had to own 60 to 120 to 500 stocks. The actual diversification math gives you little advantage once you go over 30 or so companies. So as each additional company was bought the expected returns started to lower [diversification had its costs]. This whole concept was built on the idea that you would approximate market averages. However, as discussed before there were huge questions as to sequence of returns and overall variance that indicate you are not likely to get that “average.” A great book written was “The Flaw of Averages, that goes into great detail about the faulty assumptions.

But even more crazy was the thought you could invest in stocks of companies you know nothing about and do well. That really blew my head when I realized what I was doing; investing in companies that I had put no thought into, looked at their financial picture, knew their products, etc.

If someone asked you to invest in their business, but they weren’t going to tell you anything about it, give you no financials, only that its average return on investment had averaged 10% over the last 50 years what would you say? Yet, millions of people do that with their precious savings. How many people actually look in-depth at any of the companies their mutual funds own stock in? Close to 0% I would say.

So, you are betting on a system that only gives you historical average return numbers, doesn’t encourage you to look under the hood, charges you expenses which are only partially disclosed. In any of my investment classes if I had answered questions on an exam with: “It doesn’t matter because the historical average return is X%,” what would have been my grade? Is this not the dumbest investment strategy you have heard about?
And here I was fully vested into that strategy. God……I was dumb!

So diversification is a strategy sold by experts that discourages you from doing any research on your own, use your own brain, and requires you to be math illiterate to accept its basic premises.

This was the second financial truth I discovered on my road to a real education on personal finance after the danger of high variability.

From there on out I started to use my brain.

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