I know this won't be popular, but the whole idea of "diversification" has always struck me as a lame attempt by rich people (Stock brokers) to get more money from poor people. So I roll my eyes whenever a guy with a Rolex and a Porsche is telling me I need to "diversify"
Imagine average Joe investing in a very non-diversified portfolio of one stock which he has decided he likes, perhaps due to personal knowledge of the firm.
Over time, odds are this stock will do poorly compared to if he'd had a more diversified portfolio.
It's the same general law of markets that is why it's generally better to invest in index funds... they benefit from overall increases in productivity and economic growth, without being subjected to all the risks that less diversified portfolios suffer from.
Of course, it's always possible to formulate a 20/20 hindsight critique of diversification b/c there is always an investment or two that retrospectively looks like it would have been an obvious sure thing to a layperson.
Over time, odds are this stock will do poorly compared to if he'd had a more diversified portfolio.
How are you calculating these odds? I'd naively assume that the average performance would be the same but the volatility would be much higher. Dollar cost average into it and you reduce this somewhat. I've never really understood the magic of diversity either, unless it's just to insulate against risk of ruin.
Just look at the top stocks 30 years ago and see which ones are still in business today, and of those which have beaten the market average. No stock will outperform the market over the long term. Nor will any mutual fund!
For medium time horizons it's not impossible but exceedingly unlikely.
For short time horizons it's still not remotely easy for firms to accomplish, and many do not.
This is a disappointing answer. Yes, most firms don't manage to beat the market average. The apparent answer would be that about half of them do, probably slightly fewer due to occasional runaway successes.
What you seem to be saying is that there is a complex system guaranteed to beat the expected return of buying and holding a single stock. I don't see how this can be true, although it's certainly possible that the lower volatility is preferable enough to offset the slightly greater costs.
Do you really believe that it is 'exceedingly unlikely' that a firm would exceed the market average for a 15 year period? I haven't done research into this, so I'm happy to learn. Instinctively, it would be a pretty frequent occurrence.
Are you saying that more than 95%[1] of the individual underlying stocks held by a major index fund will underperform the market over a 15 year period? If yes, how can this be? If not, what are you saying? Are you a betting man?
Surely some firms will do better than average, it's just that humans are notoriously bad at anticipating which firms those will be, hence the superior performance of index funds compared to managed mutual funds over the long term.
> I suppose it's possible for a company to exist indefinitely, but how many companies that existed 1000 years ago exist today?
How many markets that existed 1000 years ago exist today? The point I'm making is that markets are composed of individual stocks, they can't be inherently superior in terms of ROE to the stocks that the indices track.
Diversification means I need to give the stock broker more money. That's all it means to me. I understand the risk aversion concept. You don't need to "educate" me.
Telling lay people (as you call them) that they need to do this or bad things will happen is the perfect scam. Create disonance and then offer a solution.
"Repent and ye shall be saved." "Diversify and ye shall be saved." I don't buy either argument. I got out of the market in 2000, never been back. Never will.
Edit... and yes, I owned index funds, but they wanted me to buy more index funds to further diversify my holdings. I learn quickly. That's always been my problem.
How does buying an index fund mean giving a stock broker more money? It's your money, invested. You're certainly free to keep it under your mattress if you prefer. Historically, money invested has drastically outperformed money kept under mattresses :)
1. You don't invest? Let me help you start. (give guy money)
2. Good, you invest. Let me help you diversify. (give guy more money)
3. Good, you are diversified, but you need to diversify more (give guy even more money)
4. You have too many stocks. Let's get you into more bonds. (give guy money)
5. Hmm... you don't have any exposure to Far East currency, but we can't take away from your Euro position. Give me some more money so we can buy this new Chinese currency. (give guy money)
Um, why you buy an index fund and you put $1000 in, you can immediately get $1000 out. And many brokerage accounts are free.
So this is no more of a scam than a bank account, except you take on more risk in return for more reward. Not a huge risk, but bigger than the money market.
It's true that relative to inflation many investments do quite poorly, and it's true that some investing is a scam. I don't think it's true that all investing is a scam.
I know this won't be popular, but the idea of "backups" has always struck me as a lame attempt by rich people (Retailers) to get more money from poor people. So I roll my eyes whenever a guy who sells hard drives and RAIDs is telling me I need to "backup."
It's because of covariance of returns. You can construct a portfolio with the same expected return as a single stock, but with much lower expected risk, defined as variance of return. Or a portfolio with higher returns for the same risk. And so on.
Anticipating your next question, yes, in general, historical risk has a high R2 with actual risk, where risk is defined as being normalised to an index.
