Diversification Matters

Our youngest daughter is one of the most organized and disciplined people I know.  I once accused her of being “excessively moderate.”  For the rest of us, it is surprising to see what you can accomplish easily when you know what you want, when you want it, what you have to get it with, and who can help.

If we apply the idea of knowing what is required and what the resources to get it may be, we can improve our investment approach.  If we don’t know any of those things there is just a single way that might work, assuming you do anything, and that way is to diversify. Hold a balanced portfolio and hope for average results.

That works for many people because it requires almost no effort beyond saving.

What exactly does diversify mean?

For most people, there is no answer really.  The idea is to own things that do not behave the same way in given market.  For example, if I earn income by being a real estate salesman, I might prefer to invest my extra income in something other than leveraged real estate.  If things go bad in my market, both my income and my capital will be adversely affected.  In a similar way, business owners have a huge share of net worth invested in equity markets.  Their savings might be better positioned in something less volatile.

The idea of diversity is that not everything goes bad at once and not everything goes up at once.  Transferring money from the ones that are up excessively to the ones that are down is balancing.  Ideally buying something that will be up in the future.

That is the idea of a diversified portfolio.  

You can tell when you are not diversified properly.  Everything is up.  Everything up may look good, but it is not.
There is another form of diversity that matters.  Diversity in time.  Neither modern portfolio theory nor the efficient market hypothesis consider time diversity.  Buffett and others implicitly do.  Hear Charlie Munger:

“We don’t give a damn about lumpy results. Everyone else is trying to please Wall Street. This is not a small advantage.

Most conventional statistics measure year over year return for volatility (risk) and return.  For most people year to year is not relevant.  Why notice if you won’t need the money for 25 years?  History tells us that equity markets over long periods outperform fixed income.  Would making an extra point or two be worth more than less volatility in the short run?  Probably, if you understood the purpose.

Older people often claim to not have 25 years and if you are 70, that is the way to bet.  Time diversification matters then too.  The point being that no one needs all of their capital in the next 12 months.  Why use a 12 month measure?

Older people can use a rolling bond portfolio to provide for their spending needs.  If you have a year’s spending provided by interest and maturities from a portfolio that guarantees the next 5 to 7 years, why be excited about volatility in the rest this year?

Diversification can include equity, fixed income, country, sector, industry or credit rating.  Do not overlook time.  It connects your personal situation to the rest of the world.

Moderation and diversity go hand in hand. They involve understanding the possibilities and connecting to what you need. 

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.  don@moneyfyi.com  866-285-7772

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