During our weekly webinar this weekend, we were asked the question, “which of the following is considered a diversified investment?”
And it was right in our wheelhouse and we love to speak about diversification. We love to speak about investing and diversification because it is something that Wall Street talks about ALL the time. And like anything else Wall Street, it is mostly a scam or a way for you to hand over your money to them so they can charge you fees.
Without getting into too much detail (we will get into plenty of detail later), diversification is a scam. It’s a joke. It’s not real and is based off fiction instead of facts. C’mon, are you really telling me that a “sector” of a stock can be the difference between it being a diversified investment or not? Give me a break.
Here we go, our answer to the question “which of the following is considered a diversified investment?” This one is going to be short and sweet because to find out what true diversification is not difficult at all. Like many concepts in investing, you have to look under the hood at the numbers to have a true understanding of what is taking place. Diversification is an excellent example of this.
The above video is an example of the standard speech for diversification. Buying stocks in different sectors and asset classes is what most come to know diversification as.
Let’s buy a tech stock, an industrial stock, a gold stock, and some bonds and bam, we have a diversified portfolio. This way is one sector or asset class is down, the others won’t be. Wrong.
It’s Not Diversification
C’mon. Saying we have diversification because we have a little bit of this and a little bit of that is hogwash. You have to be kidding me. Let’s put their definition of diversification to the test.
Zillow is an internet real estate media company that trades on the Nasdaq Exchange. Google is not a real estate company but it is an online media company (it makes money via ads) and also trades on the Nasdaq.
If we wanted to buy some Zillow and Google, the likes of the Wall Street Journal’s and CNBC’s heads would explode because they are both online media companies and both are part of the tech sector. They would scream and yell.
What’s more is they would call Jim Cramer who would be screaming “Those are not diversified!” The obvious question I have for them is, why?
I cannot allow Zillow and Google to be label undiversified just because they both trade on the Nasdaq. That is judging a book by its cover, and if we have learned anything from our dealings with Wall Street is that there is usually something more to everything. Diversification is no different.
Which of the Following is Considered a “Diversified” Investment?
Let’s just think logically about this for a second. If we are worried that Zillow and Google might move with similar price action…how can we find that out? Surely just saying they both trade on the Nasdaq can’t do that…can it?
In order to see diversification, we are correct. We want to check the price movement of these stocks to see if they move together or not. This has nothing to do with sectors.
The way we do this is by taking the price movements of each stock over the last 365 trading days and comparing them to one another. If Zillow and Google both move up 1% on a given day, we mark that day as 100% correlation. If Zillow were to move up 1% and Google was to move down 1% on the same day, we would mark that day at -100% correlation.
Simple enough yet mind blowing to those that just listen to everything Wall Street tells them.
Zillow and Google Diversification
When we take the price movements of Zillow and Google each day, we get something that looks like this:
|Date||Close||Daily Returns||Date||Close||Daily Returns|
|4/18/2016 16:00:00||21.62||4/18/2016 16:00:00||787.68|
|4/19/2016 16:00:00||22.28||3.01||4/19/2016 16:00:00||776.25||-1.461728276|
|4/20/2016 16:00:00||23.24||4.22||4/20/2016 16:00:00||774.92||-0.1714835029|
|4/21/2016 16:00:00||23.33||0.39||4/21/2016 16:00:00||780||0.6534121465|
|4/22/2016 16:00:00||24.85||6.31||4/22/2016 16:00:00||737.77||-5.566179677|
|4/25/2016 16:00:00||24.86||0.04||4/25/2016 16:00:00||742.21||0.6000099083|
|4/26/2016 16:00:00||24.85||-0.04||4/26/2016 16:00:00||725.37||-2.295035249|
But a lot longer and larger. However, when we compare only price (fact) rather than sectors (fiction) or asset classes (fiction), this is what we find:
Now, if Zillow and Google were to have a diversification score above 50%, we would say they are not diversified. Any number below that 50% would tell us they are diversified. Clearly, a 19.71% diversification score tells us they would be diversified investments!
Wrapping Up Diversification
Which of the following is considered a diversified investment? Look no further than price movement!
Throughout this short post, we explained how looking at fiction (sector, asset, etc) doesn’t give you a lick when determining if two stocks are diversified or not. The only thing that matters is the price.
Find the price movements of two stocks. Compare them. And only at that point can you make the claim they are diversified or not.