Diversification • Year-End Wishes
Monthly AIRE Perspectives – December 2023
Dear Friends and Valued Clients,
Please see below for The MAP – Monthly AIRE Perspectives for this month.
Risk and the Case for Diversification
Concentrated positions can potentially lead to far greater returns, but also to far great losses. If you had invested in Apple stock more than 20 years ago or Tesla stock more than 10 years ago, you would enjoyed astronomical returns, especially if you had concentrated all of your holdings in those companies. However, it is important to note that returns in hindsight do not represent risk. In other words, just because an investment provided great returns does not mean that it was a “no brainer” investment at the time, and the fact that it generated a great return does not mean that there really wasn’t much risk to it after all. Both of these great companies were, at one point, literally on the verge of bankruptcy. The point here is that concentrated positions sometimes can lead to binary outcomes – you might get enormous returns, but you might lose everything. This is why we feel it is critically important to diversify portfolios.
We are sometimes asked the question: “do we really need to be this diversified?” To us, the answer is a resounding “yes!” The reason for this is because there is no such thing as a “no brainer” investment that will provide you with huge returns and minimal risk. Take the case for San Francisco commercial real estate. Less than five years ago, with office vacancies in San Francisco at less than 5% and skyrocketing prices, it seemed as though an investment in commercial real estate in that city was sure to provide great returns for many years ahead. However, as you probably know, the situation in downtown San Francisco has changed drastically in the past three years, with vacancies having now reached more than 30%. You can click here for a chart showing the changing vacancy rate in that market over the past few years.
When it comes to investing, we advise first with a focus on risk management. The field of behavioral finance highlights many investor biases. You can view a brief summary of these biases on slides 22-25 in our attached presentation on “Essential Lessons in Investing: Asset Allocation and Planning Versus Predicting.” One bias we will focus on for the purposes of this month’s MAP is called “home bias” or “familiarity bias,” which basically means that investors tend to have a tendency to feel more comfortable investing in things they may have heard of, or which may be close to their city or country of residence. For example, we often are introduced to new clients who come to us with portfolios that might be heavy in US large cap stocks, as those tend to be more of the household names we know, or others who are heavily invested in real estate in their own cities.
This this type of concentration risk can be diversified and potentially reduced by investing in other types of investments even within those same asset classes. On slide 6 of our attached presentation, for example, please notice the historical returns of small cap stocks versus large cap stocks. Historically, small caps have provided greater returns, and their expected return in the future also tends to be higher. Although small caps tend to have more volatility than large caps, diversifying a large cap portfolio and adding other areas of stocks – such as small caps, mid caps and international holdings can actually create a portfolio with lower volatility due to diversification, and potentially higher returns.
Similar benefits can be recognized by diversifying real estate holdings to more cities and countries than one’s own home city. This is why we provide holistic planning that takes into account all of a client’s assets, and not just stocks and bonds. We look forward to our continued discussions regarding your individual portfolios in the months and years ahead.
Year-End Wishes
Once again, we would like to thank you for your trust and loyalty, and look forward to speaking with you in the upcoming month. We wish you and your families a very happy holiday season and a happy and healthy year ahead! 😊
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