Has Diversification Been Resurrected?

Physician's Money Digest, September30 2004, Volume 11, Issue 18

Diversified portfolios are all therage. Yet it's good to keepremembering that many investorsabandoned their common sense as soon asthe Nasdaq started booming in the 1990s,and didn't see the light until April 2000.

Today's investors are already forgettingthat diversification was widely deridedduring the boom years. With perfectmyopia, commentators opined on thedeath of diversification, the evaporationof the small cap premium, and the failureof value investing. Critics all but placedWarren Buffett in a home for the infirm.

Keeping the Faith

Until the implosion in 2000, lots of peopleseemed to be getting rich by doingsomething dumb: concentrating all theirinvestments in a single sector of theworld's economy. The temptation to abandonperfectly solid investment strategiesat just the wrong moment became toomuch for many investors.

In a smaller way, today's hot thing isreal estate funds. You can get in just intime to suffer through the pop of thebursting real estate bubble.

Peer Pressure

Whether it's technology stocks or realestate funds, there is a large measure ofnot so subtle peer pressure at work.Individual investors or investment advisorswho maintained their discipline during theboom were accused of failing to grasp thesignificance of the "new economy," orconsidered just too dumb to understandthe "new metrics." Diversification as aninvestment policy was not a cool topic atcocktail parties. In fact, the underperformanceproved temporary. It was a natural,inevitable, and expected consequence ofthe diversification strategy.

This periodic underperformance causessome stress with investors that eitherdon't understand the portfolio designphilosophy or who cannot tolerate thesocial stigma of occasionally underperformingthe local index. This desire tolook like everybody else's portfolio is animportant psychological impediment formany investors.

Consciously or not, most people andinstitutions in the US compare their investmentreturns with the S&P 500. When surveyed,more than a few investors willcheerfully admit that they would prefer aninferior investment strategy to one thatcaused them to lag their friends. Whilethese investors realize that their constraintsare irrational, they cannot accept anyinvestment plan that does not look a greatdeal like what their friends hold.

Dare to be Different?

During periods when a diversified portfoliounderperforms the local benchmark,maintaining focus requires courage.Human nature being what it is, all friendswill be quick to point out how much betterthey are doing with their simplistic concentratedportfolios. So, physician-investorsneed to ask themselves if theycan dare to be different in order to obtainbetter returns over the long haul. If not,they should carefully decide how muchdiversification from the large US marketthey can tolerate as they design theirinvestment policy. The time to do this self-examinationis now. Otherwise, down theroad, those that can't dare to be differentwill abandon perfectly good investmentplans at just the wrong moment, again.

is the founder and principal of Investor

Solutions, Inc, a fee-only, SEC-registered investment advisor. He

is also the author of The Informed Investor: A Hype-Free

Guide to Constructing a Sound Financial Portfolio (Amacom; 2002), which is now available

in paperback. For more information, visit www.investorsolutions.com.

Frank Armstrong III