Diversification is supposed to be a good thing.
It should reduce risk and volatility.
Yet, it harms more people than it helps.
Spreading your risk amongst multiple companies can make sense if you do it correctly and for the right reasons.
But most folks force it into their portfolios, curtailing performance far more than they cut risk.
Here’s an example.
Over the last 10 years, the S&P 500 (SPY) returned 200%. This is a market cap-weighted index, meaning bigger companies make up a larger proportion of the weight.
During that same 10-year period, the equal-weighted S&P 500 index (RSP) returned 163%.
On the surface, that doesn’t seem so bad.
However, during that same period, the equal-weighted index had:
- A larger maximum drawdown
- A higher daily standard deviation (more volatility)
- A lower sharp ratio (excess returns compared to risk)
So, you get lower returns with higher volatility. That sounds like a terrible investment strategy.
But this example just scratches the surface.
Most people neither realize how many truly awful exchange-traded funds (ETFs) they hold nor how much these ETFs are costing them.
We’re going to rip off the band-aid together and look at some of the worst offenders out there.
Then, we’ll offer up some alternatives and even show you a truly mind-blowing example where a portfolio of just three stocks can handily outperform the markets.
Oil & Gas
Investing in energy is hard enough.
You can’t directly buy crude oil or natural gas. You can trade futures, which are highly leveraged. But they’re not really useful for the average investor.
ETFs, like the USO and UNG, are absolute garbage long-term holds. Just pull up a multi-year chart for either ticker, and you’ll see what we’re talking about.
The best way to play energy is to invest in companies that are involved in the sector.
Energy companies come in three flavors: upstream (exploration & production), midstream (MLPs) and downstream (refiners and gas stations).
We’re going to take a look at the SPDR XOP, a popular ETF that invests in exploration & production (E&P) companies.
E&P companies live and die by the price of oil and natural gas.
The majority of their money is spent on big drilling rigs. So, they produce as much as they can. The higher they can sell that barrel of oil, the better.
What you probably didn’t know is that the sector has changed over the last decade in favor of consolidation under large companies.
That’s lifted a few names to huge market capitalizations, while leaving the rest in the dust.
The XOP restricts investors with its equal-weighting market cap. You get all the exposure to volatile commodity prices without the benefits of big companies that get larger.
Compare that with the iShares IEO ETF, a market-cap-weighted product.
Here’s what you get over a 10-year lookback period:
Source: Tradingview
The IEO, represented by the orange line, returned 82% over the last decade.
The XOP, represented by the green line, lost 25% over that same period.
That’s a huge difference. What’s behind it?
Conoco Phillips makes up almost 20% of the IEO.
The top five companies make up nearly 50% of IEO’s total weighting.
The outperformance over the XOP is mind-blowing.
So, what causes this?
The True Winning Strategy
In a nutshell: let winners run.
This isn’t meant to be an overarching theme for trading and investing.
What we’re saying is that a company that gets larger over time usually does because it’s a good business.
Obviously, bubbles form and burst.
But those short-lived momentum trades aren’t going to screw things up dramatically. These ETFs don’t change their holdings often enough for that to happen.
It also harkens back to a philosophy of the late Charlie Munger: buy an excellent company at a reasonable price.
Good companies tend to last.
The oil industry is a perfect example of a sector that’s been disrupted by fracking technology.
Thousands of smaller companies disappeared in under a year.
But behemoths like Exxon Mobil didn’t just survive, they scooped up these assets at rock-bottom prices.
That’s how folks like Jim Woods are able to craft what they call the Perfect Portfolio.
You see, over the last several decades, Jim noticed that certain stocks would outperform the market month after month, year after year.
Although there are literally thousands of tickers to choose from, all you need is three.
As crazy as it sounds, Jim discovered that his three-ticker portfolio would outperform the markets… and not just by a little.
Folks heavily criticized his project, saying it lacked diversification.
Hopefully, we’ve shown you today that diversification, for its own sake, isn’t just a lousy idea. It can cost you a fortune.
But don’t take our word for it.
See the proof right here for yourself.
