Former Defense Secretary Donald Rumsfeld was famous for quotes such as the following: “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.” In this missive, I would like to address the fact that what we think we know may produce unforeseen consequences.
One of the more popular pieces of financial advice that people receive is: “don’t put all of your eggs in one basket.” This phrase can have different applications, some of them valid, but other times not. For example, if the quote refers to diversification, it very definitely can make sense. Unfortunately, many people tend to take a good idea, such as diversification, and misapply it so that they can be worse off than if they ignored the advice in the first place.
For example, some people interpret diversification in terms of “the more the merrier.” This thinking typically manifests itself when we review people’s 401(k) or brokerage statements. If there are ten investment options, people will think that holding all ten in equal weights is better than concentrating in just a handful of investments. We have also seen examples of people diversifying into much of the same asset class. An example of this is a portfolio consisting of five different government bond funds. In this case, there is no diversification if all of the investments will behave exactly the same.
Another misapplication of the phrase “don’t put all of your eggs in one basket” is how some people spread around their money in different institutions, with the thought that if a bank or brokerage house goes down, they will lose everything. That may have been the case in the 1920’s or 1930’s, but today we have a very robust and highly regulated financial system.
We have also encountered people who feel that they are protecting themselves by parsing out their investments over a wide variety of advisors. They may believe that they are protecting themselves from malfeasance, or they may attempt to pit the performance of one advisor against another; again, to them it just seems prudent not to put all of their “eggs” in one basket.
Here are some of the problems that can result from following that strategy. It can be very difficult for an investor to determine exactly what their returns have been like, weighted for the amount invested with each advisor. Frequently, people will pull out a sheet of ledger paper or a spreadsheet where they have struggled to estimate what they believe their results were for the year. Often times they miss the mark by a wide margin, especially if their account had significant additions or withdrawals.
Another unintended consequence can be fragmenting your funds in so many different directions that no one pays serious attention to the piece that they are managing. Sometimes people become irate by the lack of attention that their investments receive, but sometimes they do it to themselves.
Putting your investment “eggs” in multiple baskets can result in adverse tax consequences. One advisor may be trying to create a very tax efficient portfolio that is being completely negated by another advisor whose approach is agnostic to tax implications.
Perhaps the greatest unforeseen consequence of splitting your assets among multiple advisors is the irony that, due to a lack of communication between advisors, you may be constructing a “portfolio” that no one in their right mind would ever create. Think about that for a moment. One of the greatest dangers to diversifying your assets across multiple advisors is that you may be negating the benefits of a coordinated diversification strategy.
To paraphrase Donald Rumsfeld, there are things that we know that are true. How we interpret this truth and how we implement this truth can lead to wildly different outcomes that most people cannot imagine.
Warren Buffett is never afraid to make concentrated investment bets. Why? Because he understands what he buys. If you are over-diversifying, your lack of understanding could cause you undue angst.