Diversification is the greatest lie ever sold. Commercial investment advisors sell numerous lies to their clients on a frequent basis, like derivative products they promise will provide great returns like Abacus that end up being among the worst products ever, that gold is a barbarous relic and not important to wealth preservation, that they have bought physical silver under a physical silver contract when they likely only bought paper silver while charging storage fees for storing non-existent silver, and on and on. The lies are so great, one could probably publish a full book full of just investment advisor lies exposed not even in history, but just since 2008.
However, of all lies spread in the commercial investment industry, diversification is the greatest lie ever sold. Many faults of diversification in portfolio strategy have been evident for decades, but yet diversification strategy remains one of the strongest pillars of commercial investment firms. Since the evidence is overwhelmingly against diversification strategy as a wise strategy, the question remains, Why do commercial investment advisors remain so committed to diversification? The first time I’ve made the above claim was well over a decade ago, and I’ve stated it many times since, and this time probably won’t be the last time I discuss this topic. However, this year is an especially easy year to make an argument to expose the faults of diversification in portfolio strategy. If commercial fund managers are so insistent that diversification strategies work, then why have the bulk of them completely ignored the best performing asset class of 2016? What kind of diversification is that? (I will refute some of the better-known arguments in response to this question later in this article, so stay tuned.)
Consider that despite the stellar performance of gold mining stocks this year that have been, by far, the strongest performing asset class of 2016 (along with silver mining stocks), and that even with the massive growth in market cap of PM stocks during H1 2016, the total market cap of all the mining stocks that comprise the HUI Gold Bugs index, as of 2 August 2016, is still barely larger than 1/3 the market cap of Facebook and Amazon. In fact, we could own every single company in the entire HUI gold bug index, and their total market cap would incredibly be less than 1/4 the market cap of one company, Apple. Should Apple’s market value really be in excess of 4-times the market value (the cumulative market capitalization) assigned to all the companies that comprise the entire HUI gold bugs index, and all the gold reserves and resources held by them? Should Facebook, a glorified advertising company masquerading as a social networking organization that produces no tangible product, really possess a market value nearly 3 times all the gold mining companies that comprise the HUI Gold Bugs Index? The market will tell us that the answer to both these questions is yes. In my opinion, however, the answer to both of these questions is a resounding no, and I believe that within the next couple of years, the market will violently correct these misconceptions. So even with the great run higher in the prices of gold (and silver) mining share prices, the market is still underpricing these shares considerably.
In my opinion, there is no better inventory for a company to own, given the grave fragility of the global banking and finance system, than the only real, sound money in the entire world, proven and probable reserves of physical gold and physical silver. (Sorry, BTC enthusiasts, the answer is not bitcoin, even though I fully support open currency competition, including all cryptocurrencies. However, the recent 30% dump in the price of BTC in just 2 days, after Hong Kong BTC exchange Bitfinex was hacked and nearly 120,000 BTCs were stolen, deftly illustrates that there is no substitute for physical gold and physical silver. While BTC will rebound in price from this event as it has in the past from similar events, and cryptocurrencies provide a good mechanism to move currencies around the world outside of the authority of governmental capital controls and tracking, they still leave a lot to desire in terms of fitting the “sound money” definition. Just perform a Google search of the formerly most hated female at JP Morgan, “Blythe Masters” and “cryptocurrencies” to understand how bankers are trying to transform the use of digital currencies into just another tool of control.) Yet, despite the reality of PM Mining Stocks being the best performing asset class by far in the stock world this year, nearly every commercial bank and commercial brokerage fund manager completely avoids the asset class of Precious Metal mining stocks like it is kryptonite, and in fact, most of the time, refuses to even acknowledges the existence of this unique asset class, despite a supposed commitment to diversification. In fact, in the commercial investment industry, one of the greatest faults of diversification in portfolio strategy is that despite its devotion to diversification strategy, there is a near zero allocation to physical gold and physical silver (paper ETF gold and silver products are not a viable proxy for real physical gold and silver!) Incredibly, even though diversification is the greatest lie ever sold, commercial investment advisors universally fail to diversify into physical gold and silver for their clients.
As those of you that have been following my writings since 2006 know, including the more than 600 postings on my blog, I used to work at a Wall Street firm more than 10 years ago, before I quit in disgust after witnessing systemically fraudulent practices. However, it may surprise you to discover that I considered portfolio diversification strategies to be one of these systemically fraudulent practices. Before any of you doth protest too much about this conclusion, let me explain the rationale for my inclusion of diversification strategy among the other much better known systemically fraudulent practices regularly engaged in by big commercial brokerage firms and banks.
Most people never ask their financial advisers about their educational backgrounds, and just assume that their adviser retains a certain level of investment expertise. I guarantee you 100% that this assumption is incorrect. In fact, one of the most surprising aspects I learned about financial advisers while working for a Wall Street firm back in the day was the enormously diversified pool of educational and professional backgrounds from which managers plucked their team of financial advisers. Some of my peers came from liberal arts background, teaching backgrounds, government/political policy backgrounds, sports backgrounds and science backgrounds just to name a few. And what was my background? I majored in neurobiology as an undergraduate. Sure, I later obtained an MBA with a concentration in finance, but I also guarantee you that this advanced degree taught me next to nothing about intelligent investment strategies, including forwarding the incorrect narrative of diversification as an intelligent investment strategy instead of correctly exposing that diversification is the greatest lie ever sold. Much to my chagrin, I learned a bunch of theories in school that don’t even apply in the real world of dark pools and computer HFT algorithm controlled markets. In fact, back then, my manager that hired me seemed more interested in the psychological profile I completed as part of the application process versus my possession of any real investment advisory qualifications, as a sales mentality combined with the naivete of adopting a diversification strategy seemed to be the important qualifiers for “success” within the industry.
At this point, most people will inquire about a firm’s training program, believing that this program provides the necessary skills for financial advisers to formulate intelligent strategies under all market conditions and not just raging, bloated, Central Banker induced price distortions higher. Again, this assumption would be wrong. Our training program, by my estimation, was 90% focused on closing sales techniques to capture AUM (Assets Under Management) and block and bridge techniques to overcome client objections during the closing process versus the development of any real strategic investing acumen. Of course, many among us may be reading this, thinking “tell me something I don’t already know. I already know that diversification is the greatest lie ever sold,” and if so, this article is not intended for you. However, every single year, I still casually meet loads of people that tell me the most important part of their wealth building plan is diversification. This article is intended for this subset of people.
But I digress. So how did so many people with little background, if any, in investing and/or finance, and some with no background at all, become the most successful financial advisers at the firm (as measured by AUM fees generated), you may wonder? That is an excellent question that took me a little while to discover the answer to as well. During my years spent in the commercial investment world, I came to the conclusion that diversification strategy was by far, the most important key to not only the success of firms in capturing hundreds of millions in AUM, but also the key to preventing assets from leaving during poor performance years as well. The use of diversification as a long-term strategy in ensuring clients can be retained within the commercial investment industry when performance is horrible across the board is one of the most important concepts to grasp in understanding that diversification is the greatest lie ever sold. Diversification is a key strategy that makes it difficult for clients to jump ship to another investment firm during a poor performance year.
If every commercial firm utilized the same diversification strategies, then in up years, every firm’s financial advisers more or less returned the same yields within a tight range to their clients, and in down years, every firm’s financial advisers more or less returned the same losses within a tight range to their clients. If every other firm lost roughly the same percentage of money for their clients in a down year, why bother jumping ship to a competing firm if you were a client, right? Thus the industry-wide adoption of portfolio diversification strategy was not executed to benefit clients, as is sold to naive clients, but done to benefit the firms within the industry in maintaining AUM fees, and also to serve as insurance that firms could maintain their clients during poor performance years. Think about this situation for just a few minutes. If portfolio managers were really so important to portfolio performance, as this narrative is sold to all investment industry clients, then why are portfolio managers that defy poor returns in a year stock market indexes perform so poorly as well as portfolio managers that significantly outperform stock market indexes during solid up years so rare? Should not performance fall along a bell curve, unless diversification is the greatest lie ever sold?
You see, because diversification is the greatest lie ever sold, it really doesn’t matter at all if a financial adviser knows what they were doing, because selling diversification strategies to clients makes it sound like they know what they are doing, which was an infinitely better proposition for commercial investment firms than employing financial consultants that actually are competent and know what they are doing. Yes, the analogies to convince clients of diversification strategies arre clever, like comparing the necessity of a diversified stock portfolio to the necessity of a diversified, well-balanced diet that consists of a balance of protein, fat and carbohydrates. The only problem with this analogy, no matter how clever it may be, is that this narrative has always been patently untrue.
Consider the global stock market crashes that afflicted the world in 2008. No matter how well someone’s US stock portfolio was diversified that year, if they remained invested in any diversified portfolio that mirrored US stock market indexes like the S&P500 or the Dow Jones Industrial Average, as is the overwhelming case with portfolio asset allocation among fund managers, they lost 40% or more that year in their diversified portfolio. In 2008, we maintained a very concentrated Crisis Investment Opportunities portfolio allocated to just a couple of asset classes, and we ended up the year with not a lesser 20% loss against the 40%+ losses of a diversified US S&P500, but we ended up with slightly positive yield for the year (to discover our current services, which focus on wealth education and the best gold and silver education courses, click here).
And if diversification is such a wealth protective strategy, can you guess which commodity firms declared the largest impairments to their balance sheets by far in 2015? The most diversified ones: Glencore, Vale, Freeport and Anglo-American. These four massively diversified mining giants declared cumulative impairments in 2015 that nearly totaled $36 billion. Of course, one of the reasons their declared impairments were so massive was simply due to the giant size of these corporations, but the fact of the matter is that diversification of their business segments into many different commodities didn’t help these companies from suffering massive losses in 2015 and diversification didn’t prevent US stock portfolios from crashing in 2008. Even among the mining industry, diversification is the greatest lie ever sold.
So why exactly is diversification such a great strategy if it only works when a bubble is building but fails miserably to preserve wealth when a bubble implodes or a significant downturn occurs? The reason commercial investment firms and commercial banks all over the world, no matter if they are located in Cologne, Madrid, Reykjavik, Buenos Aires, New York, London, Wellington, Melbourne, Toronto, Vancouver, Montreal, Shanghai, Kunming, Hong Kong, Singapore, or Nairobi try to convince all clients to embrace diversification strategy as an essential part of their wealth building plan is not because it actually works, but because it covers up the weaknesses and flaws of an unqualified financial consultant. Diversification strategies appeared to have “worked” during the golden years of the 1980s and 1990s, simply because US stock markets were returning 17% to 18% every year on average during those two decades and Stevie Wonder could have pointed to a bunch of stocks from a newspaper listing the components of the US S&P500 during that period and likely would have fared very well. Thus, the “success” of diversification strategies was confused with luck during these times and such a strategy even provided incompetent financial consultants with a cover of credibility as it empowered them with an undeserved veneer of competency. However, the ability to sell the appeal of diversification, as I explained above, completely changes when yield becomes much difficult to achieve than just throwing darts at a board, and one really has to understand market risks to formulate strategies that can produce significant yield during difficult times. At this point, reliance on a diversified bubble of assets to further significantly inflate to produce yield pulls the curtain back on the diversification scam and reveals diversification is the greatest lie ever sold.
As Credit Suisse’s Andrew Garthwaite discovered, during these times, the weakness and low utility of diversification is really exposed. If a strategy only works when everything is working but doesn’t work in years when times are tough, then I would argue such a strategy is a bad strategy. Just last month, it was reported that Credit Suisse strategist Andrew Garthwaite lamented dismal yields for the past couple years in a client report, writing that “his team has come across almost no one who seems to have outperformed or made decent returns this year” and “we have never had so many client meetings starting with statements such as ‘we are totally lost’.” The reason that Garthwaite’s team cannot find anyone that has made decent returns this year and are totally lost is because his team is likely diversified in the types of asset classes that only work when stock markets are not price-distorted bubbles. Garthwaite’s team’s failure to perform this year likely is due to their refusal to deviate from past strategies and their likely failure to concentrate on only asset classes that are highly undervalued, such as PM mining stocks.
Garthwaite’s commentary takes me back to a conversation I had with a top producer in my office when I worked for a Wall Street firm back in the day. Back then, when I asked this top producer how to become successful, he answered (and I’m paraphrasing here to the best of my memory) that I should not waste any more than 10 to 15 minutes making asset allocation decisions once I closed on a large account. I remember him being very explicit that the pathway to success was to focus on closing 1M+ AUM clients and to not “waste time” on asset allocation decisions, instead taking no more than 10 to 15 minutes to assign this responsibility by making four phone calls to four pre-picked portfolio managers, a small-cap, a mid-cap, a large-cap and an international stock manager, each of whom should receive 25% of the account’s assets. In other words, my job was to promote the diversification narrative and to promote diversification as the greatest lie ever sold. From there, my job as a financial adviser was done, and my role, if I wanted to be successful, was to go out and capture the next $1M or $5M to build my cumulative AUM figure. And with building my AUM total, this was the way to keep the firm happy and be rapidly promoted. In fact, I often heard stories of a new “star” financial adviser arriving at our firm after blowing up their clients’ portfolios at another competing firm. When I would ask why such a person would be given a bonus of 1M+ to come to our firm if they lost considerable amounts of money for all their clients at a previous firm, the answer I heard time and time again was because such a person was awesome at building AUM. After hearing this advice from a top producer and hearing these stories, there was no longer any question in my mind that the diversification strategy was a systemic scam of the financial industry and that faults of diversification in portfolio strategy were almost too numerous to count.
The point is that I discovered that most commercial investment firms could care less if their financial consultants/ advisers know next to nothing about investing, and spend less than 10 minutes per client in determining a client’s asset allocation, as long as they are racking up the AUM fees. If one’s counterargument to this fact is that this particular task is the job of a portfolio manager, then (1) why assign such misleading titles like “financial consultant/adviser” to their employees when salesman is a more appropriate title; and (2) why does nearly every portfolio manager employed by commercial investment firms stick to low-utility diversification strategies that consistently underperform non-managed, passive index funds year after year?
More than a decade ago, during my meetings with these portfolio managers, if I inquired as to whether the manager had any gold and silver mining stocks in his “diversified” portfolio, the fund manager always answered no. When I probed further, they stated that they never considered gold and silver mining stocks because their small market capitalization made them “too risky”, even if they were a small-cap portfolio manager. The large-cap managers stated that they may consider well-diversified, large-cap, mining stocks like BHP Billiton for inclusion in their portfolio, but that they couldn’t consider other mining companies solely focused on gold or silver production because their smaller-cap size and share prices didn’t meet their fiduciary mandate. Again, I understand if a large-cap fund manager that is restricted by a fiduciary mandate can not buy any PM mining stocks, but small-cap portfolio managers that also avoided PM mining stocks like they were the plague always provided excuses that were pure rubbish. Remember, I last worked in the commercial banking and investment industry over a decade ago, when the bull market for gold and silver was just getting started and the best gold and silver mining stocks were soaring in share price. Most likely, small-cap portfolio managers utilized the too much “risk” excuse back then to mask an utter lack of knowledge regarding how to properly assess a gold and silver mining stock’s value and upside potential. And though it remains true that volatility in gold and silver stocks will always remain much higher than physical gold and silver, as I stated above, I did not know of a single “advisor” that recommended his or her client buy the much more price stable, and appreciating asset of physical gold and silver. Back then, when I still worked in the industry, gold was not even $500 an ounce.
Back then, there were junior gold and silver mining companies that were a fraction of the market cap of their much larger-cap mining peers that had much stronger management, had managed geopolitical risk in a superior manner, and had streamlined operations to a far greater degree than their larger-cap peers that were not huge risks. Today, these arguments are even more applicable, and one can find junior gold and silver mining companies that are much better bets than their larger cap peers. I have uncovered many instances in the gold and silver mining world in recent years of smaller cap companies that acquired gold and silver mining operations from their much larger peers and (1) turned around the operations of a PM mine that was woefully mismanaged by their larger peers, (2) improved recovery rates of the metals, (3) increased exploration and successfully increased reserves and resources, and (4) even improved the grade of ore being mined with the employment of different mining techniques and the sale of non-core assets. To learn how to conduct such analysis confidently yourself, consider taking our gold and silver education courses at skwealthacademy.
In a day and age in which regular asset classes that commercial portfolio managers normally consider have become overwhelmingly bloated in price as a consequence of the persistent and extended cheap money policy of global Central Bankers, an investment strategy of concentration in few select still undervalued assets versus diversification is likely the only strategy that will work moving forward in returning significant yields. As support of this thesis, just read some of the archived links I’ve provided below. In conclusion, when managers refuse to buy gold and silver mining stocks in their “diversified” portfolio because they consider them too “risky”, even in an environment in which they admit nothing is working, we should dig a little deeper to learn the truth behind their refusal to ever deviate from their stubborn adherence to diversification strategies that don’t work, even when diversification is the greatest lie ever sold. If fund managers are trying to pass off some of the best safest assets today as risky, simply because their mandates restrict them from investing in them, then it’s time for us to take back control of our own wealth management. Currently, there are a lot of junior gold and silver mining companies I would rather own moving forward for their upside potential of their valuations versus owning Facebook and Amazon, and frankly, we should all feel the same way as well.
Other recent articles from maalamalama:
Can You Imagine the Mass Media Headlines if the S&P500 Index Were Experiencing the Same Year as Gold and Silver Stocks?
The Current Fall in Gold and Silver Prices Will Prove to be Just a Lull in a Continuing Uptrend That Started Last Year
Proof that the Largest Gains in the Best Gold and Silver Mining Stocks are Still Ahead
About the author: JS Kim is the Managing Director and Founder of maalamalama, a fiercely independent research, consulting and education firm that focuses on gold and silver asset investment strategies as a means of countering the damaging effects of rapidly devaluing fiat currencies worldwide and price-distorted stock market and asset bubbles created by Central Bankers. YTD, his Crisis Investment Opportunities newsletter has more than tripled the yield of the US S&P 500 after also returning positive yields last year, at a time in which the HUI gold bugs index declined by more than 50% from January 2015 to January 2016.