Everyone knows about diversification as the defense to nasty surprises in a portfolio. It is the “What do we mean by diversification?” that causes the problem. We must understand meaning before we can implement successfully.
If diversification means buying a Swiss Army Knife instead of specialized tools, you will do badly.
The conventional wisdom is to buy a balanced fund or do it yourself. Depending on age, it could 60% equity, 30% fixed income and 10% cash. Maybe 40-40-20 if you are “conservative” or older.
That is really too narrow to be useful.
People manage their portfolios with a key element missing. Time! If time is introduced some questions become more easily understood.
Start with when do I want to convert my securities back into money? All at once or a little at a time? If it is far in the future or takes a long time to liquidate then the traditional measures of “Risk” make little sense.
Those measures relate to the variability of one year returns. One year return is not really an issue if your time horizon is 30 years long. Presumably the smart people invest with that 30 year time frame in mind and seek yield and predictability just like everyone else. But, they don’t care about predictability 12 months from now, because 12 months from now is irrelevant to them.
This is an elementary point and most people miss it. Take a look at Day 1 in Andy Martin’s book DollarLogic.
There are psychological skills they must learn because these people look at returns once in a while and dislike down as much as the rest of us. The psychology of loss, once overcome, will allow people to pick an equity/other mix that relates to their time, not some economist’s idea of measurement.
Experience shows that over long times the equity markets are more stable than fixed income and provide higher yield. Wanting lower volatility year-to-year has a very high price.
The first thing people notice when they think about it, is time frames are much longer than they thought. If I am 40, and want to retire at 65, my time frame is not 25 years. 25 years is the beginning of spending. A couple aged 65 can reasonably expect that at least one of them will live to 90. Some of the money that is there at 65 will still be there at 90. From now a 50 year period.
Dollar-cost averaging is a form of time diversification. So is a monthly withdrawal later. Other things like emergency funds, education plans, car purchase and so on, require a different approach because the time factor is different. Study variability around those expenditures too. It will be different from your long plan.
Time diversification adds other values too.
There are tax plans that make sense if you look at them over a long time. If you put money into a plan each year and then took it out 12 months later, it would make no sense and the tax sensitive investment cafeteria would have nothing on the counter. 40 year tax deferrals are very valuable.
The time diversity allows you to ignore news and pundits. You can invest that time and trouble into selecting securities. There is no rush to buy good businesses. They will still be there in six months. Buy securities that will still be good businesses in three or four decades. All value investors use that approach. What would it take to put Proctor & Gamble out of business?
Star value investor Seth Klarman requires value investors to be patient. Brave and disciplined help too.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772