There are two sides to diversification. On one hand, it ensures you’re never 100% exposed to the worst-performing asset class. On the other, it means you’ll never have 100% exposure to the best-performing asset class either.
There’s always a trade-off.
It sounds obvious, but in practice, it’s difficult. When a particular sector or region delivers massive returns, the narrative will always suggest:
(a) why it was obvious that that sector or geography was the top performer of the past, and
(b) why it is obvious that that particular sector or geography will continue to be the top performer for the future
On this basis, it logically follows that you should invest all your portfolio in that particular sector or geography. And yet, this contradicts the initial idea of diversification.
Right now, the dominance of the U.S. market—particularly tech—is undeniable. Over the past seven years, the S&P 500 has delivered 18% per year in rand terms. While the JSE’s 9.7% per year isn’t bad, it pales in comparison.
Looking at this chart, doesn’t it logically follow that we should all just invest 100% in the US?
Here’s another interesting chart.
It shows the performance of the U.S. market relative to the rest of the world (Europe, Africa, Asia, etc.). What’s clear is that the U.S. has been on a tear—massively outperforming in recent years.
And yet, looking back further, we see what appears to be a cyclical pattern of outperformance and underperformance.
Now, let’s look at another graphic showing the top 10 largest companies in the world by decade. The chart starts in the 1980s, when energy companies dominated. In the 1990s, Japanese companies took the lead. By 2000, internet companies were at the top, and in the 2010s, many believed that Chinese companies would take over the world.
Well, in 2020, the view is firm that US tech companies will take over the world. What will this list look like in 2030?
Maybe today’s tech companies will continue their dominance. After all, these are some of the highest-quality businesses ever. But it’s also possible that the leaders of today won’t be the leaders of tomorrow—just as history has shown, decade after decade.
If that happens, what does it mean for portfolios that are heavily concentrated in one sector or country? It means risk and possibly regret. Without diversification, if the tide turns, there’s nowhere else to turn.
No one knows when the next crash will come, what will cause it, or which companies will emerge as the winners. But what we do know is that markets move in cycles, and over-concentrating in today’s winners could leave you stranded tomorrow.
This is where Charlie Munger’s philosophy is so useful. He often said:
“All I want to know is where I’m going to die, so I’ll never go there.”
Munger’s approach was simple—instead of trying to be a genius, just avoid making massive mistakes. The easiest way to ruin your financial future is by betting everything on what’s working today and assuming it will work forever.
Diversification isn’t exciting. It won’t make you feel like you’ve outsmarted the market. But it keeps you out of harm’s way, and that might be the most important thing of all.
