Rethinking Diversification
- Dominick Paoloni
- September 12, 2024
- 3:28 pm
It’s What You Don’t Know…
Mark Twain once said, “It’s not what you don’t know that will hurt you. It’s what you think you know that isn’t so.” This quote highlights a fundamental flaw in human behavior: the belief that we possess unique knowledge when, in fact, we often rely on assumptions shared by the masses. Research shows that around 75% of people tend to follow the crowd, often choosing to go along with popular opinion rather than making independent decisions.
In ancient times, following the crowd was a survival strategy. Early humans imitated behaviors that were essential for sustaining life. Today, this tendency to conform is evident in the way large groups mimic social media influencers, adopting their fashion, behaviors, and lifestyle choices. For instance, when a specific color, like grey, becomes trendy, people start incorporating it into their wardrobes and home decor. Well-known brands such as Nike, Adidas, and Zara benefit from this herd mentality, with consumers gravitating towards these brands simply because others are doing the same. known brands such as Nike, Adidas, and Zara benefit significantly from this herd mentality, as consumers gravitate toward these brands simply because others do.
Stock Market Crashes
Herd behavior played a crucial role in the 1929 stock market crash, which led to the Great Depression. As stock prices soared to unsustainable levels, panic selling ensued when confidence evaporated, causing the market to collapse. Similar patterns were observed during the Dot-com bubble of the late 1990s and the housing market crash of 2008.losses when the bubbles inevitably burst.
Financial Planning
In the financial sector, herd mentality is evident in the widespread adoption of Modern Portfolio Theory (MPT), which was developed in 1952. MPT promotes diversification as a key to financial freedom. However, events like the 2008 market crash revealed that diversification did not always protect investors.
Firms like IPS Strategic Capital advocate for hedging rather than diversifying, comparing it to insuring a home rather than spreading out ownership across multiple properties. We don’t diversify our real estate to protect our investment, we hedge it or buy insurance on every one of our properties. We do the same with our cars. We don’t own 3 cars and say, if one of my cars get totaled, I have two other cars. We hedge or insure our risk.
So why does the whole world diversify their money, Warren Buffett once said Diversification is only required when you don’t know what you are doing.
Diversification Sells Products
The Reason why Wall Street Sells Diversification is it is very profitable, Just in Annuities sales alone in 2023 advisors sold over 368 billion dollars’ worth of annuities , which was the number 1 product sold to seniors in the country. Of Course, the fact that it pays the highest commissions is absolutely a coincidence. The sale of Mutual Funds, ETF’s and private equity generate billion in Fees.
A Hedged Portfolio Comparison
Let’s consider a $100,000 investment over the last 23 years. A typical 60% stock and 40% bond diversified portfolio would have grown to $426,708. In contrast, the IPS Hedged Structured Note, with 85% participation in the S&P 500 and hedged against risk downside, would have grown to $835,418, with zero downside risk. This contrast underscores the difference of hedging strategies versus diversification.
Conclusion
In conclusion, while herd behavior has evolutionary roots and can simplify decision-making in complex environments, it can also lead to significant financial losses and missed opportunities. When one looks at the hard data, hedge your investments instead of diversifying is a far better why to invest. The only reason everybody is doing it is ,the herd mentality and diversification drives huge profits for big financial institutions.
