The Opportunity Cost of Diversification
Investing is hard. If there was an easy way to go about it, then, welp, everyone would do it until it wouldn’t work. Or so go the financial theories.
One of the best ways to illustrate this is the difference between asset class returns during different time frames. For example, we have Small-Cap stocks vs. Large-Cap. Yes, I know finance jargon. Finance types (like me!) are annoying. Cap stands for market capitalization — how much the market values a company.
One of the best performing strategies over the last twenty years is Small-Cap Value. Its cumulative return is +597% (annualized at +9.5%) vs. the S&P 500’s +374% (+7.5% annualized)¹. S&P 500 is the standard benchmark for Large-Cap company performance.
So, just put your money in small-cap value stocks and outperform, right? Eh, hold off on your private island dreams. In the last five years, Small-Cap Value has underperformed the S&P 500: +11.3% vs. +17.8% annualized².
Now, +11% annualized return ain’t too shabby, but the opportunity cost of doing just Small-cap Value has been substantial — over 6% annualized.
This is where the rubber meets the road in investing. What’s your plan when this happens? Invariably every strategy will underperform at some point. Will you make a change? If not, how much longer are you going to stay committed? What will push you over the edge?
Or your plan from the beginning could be to have a diversity of strategies. That way you’re never underperforming and participating well in all market environments. This is called diversification.
With diversification, you’re never going to be hitting home runs, but you’re neve striking out. This is the opportunity cost of diversification. The goal is to consistently hit singles and doubles³. Doing that isn’t as fun or sexy as bragging at the cocktail party about your latest home run investment. However, it is the best evidence-based way to accumulate wealth over the long run.
The major cost of diversification is always having something in your portfolio that isn’t having lights-out returns. If you have had Small-Cap Value in your portfolio the last five years, you’re kicking yourself how it’s underperformed vs. the S&P 500. Some people can handle that emotional cost. Others can’t because they never developed a plan from the beginning and end up chasing returns.
So, how do you decide on your diversification?! That decision is up to you and your advisor. Want to swing for the fences or prudently grow your assets over time? There is no right answer, but there is a personal one. And that’s why it’s personal finance!
Feel free to reach out with questions.
- Performance data is from Koyfin
- With investing there is usually a counterpoint. During the dot-com bubble, Small-Cap stocks had a positive performance during the crash while Large-Cap cratered to -40%; mostly from the huge valuations that pushed tech stocks into the Large-Cap space.
- Kind of like Moneyball…find the best strategy over time using data and stick with it!
