Defence Wins Championships. Investing Should Be Mostly Defence

I enjoy pool.  Snooker in particular.  While I have never been especially good at it, there is a lesson that applies elsewhere in life.

It doesn’t matter what you make; it matters what you leave.

What you leave is the defensive part of the game.  What you make is offense and less important. Sadly, like basketball or hockey, offense is fun and defense is work. Just like your investment portfolio.

The first rule of making money is “Don’t lose money.” Defense matters and it is not very exciting.

Stock selection with a margin for safety is defense.  Usually not fun.  Difficult even. Certainly not fashionable.

Diversity is a defense and a little overdone usually.  Ben Graham decided a range of 10 to 30 stocks would be enough for diversity, but he had a built in margin of safety that is unusual for most people. If you acquired them randomly, statistically speaking owning 50 to 100 stocks would be good enough diversification.

I like to think portfolios are not randomly selected, but I would believe that some are only slightly better.

There is no chance you will end up with a perfect portfolio, so don’t try to go there. Ritholtz Wealth Management recently noted that in the 90 years ended in December 2015, 20% of all the gains in the stock market were accomplished by 14 of the 26,000 or so issues. Corporate Inequality. Hard to know which ahead of time.

Part of your diversity problem arises when the portfolio includes index funds and ETFs. Do they count as a single dot on the diversification chart or should their underlying characteristics be included? If 70% of my portfolio is an S&P Index fund, should the rest be small cap or foreign?

The risk with mindless diversification is that eventually you have the Noah portfolio. Two of everything. Diversification is meant to decrease volatility.  Owning some of everything increases exposure to real risk and it may not drive down volatility. Fund managers seem to grasp this better than the rest of us.

Another form is time related risk management. If I don’t need the money for anything in the next 20 years, why should I care about volatility in the next quarter. So long as I pay attention to fundamentals and my margin of safety, in the 20-year cycle diversification may not be my friend.

Or maybe notice how the market works.  Bull markets last far longer than bear markets at 12 years or more. Bear markets are shorter and sharper. If you expected bull market to last a decade or more and bear markets to last less than two years, would it not make sense to change your portfolio mix depending on where the market cycle is.  Very defensive towards the end of the cycle, very aggressive near the beginning. Take a look here.

All of the issues surrounding portfolios address a simple human conflict.  Growth versus security. If the cost of growth, (variability) is uncomfortable, then greater security, (predictability) can be achieved by diversifying the portfolio. The price is loss of yield.

Be sure you know what your comfort costs in the long term.

Some people would prefer to save a little more in less volatile instruments. There is nothing wrong with that. After all, the reason you own money is for your comfort. Yields and the portfolio balance are just numbers.

Notice Steven Covey:

“The main thing is to keep the main thing the main thing”

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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