moneyFYI
Financial Freedom Is Merely Organized Common Sense
Diversification Works Only When You Do It
Every investor who wants to narrow the band between best year and worst year for their portfolio diversifies. They want predictability more than the the best possible yield. They know the best possible yield is something that is unpredictable. So they accept some investments that produce less to protect themselves from potential catastrophe.
The trick is to actually do it
Do you think you can do it by yourself? Probably. As we will see it is not so easy as we think.
I found this article yesterday at Institutional Investor. The Damning Data On Institutional Mistakes It seems that analyzing upwards of 200 insititutioanl portfolios over four years found some issues.
- “investors had almost twice as much uncompensated risk, such as currency or large sector bets, as risk for which they were actually paid” Do you address currency risk? Do you invest most in sectors you understand? Maybe you like tech and ignore consumer durables.
- “commonly held so many stocks that they cancelled one another out” That is “deworsification. ” Why pay a fee when the choices cancel each other?
- “Uncompensated risks washed out about 50 percent of all the active risks that investors were taking in the studied portfolios” You pay double for a given risk profile
- “This report shows that people learned the lessons, but haven’t applied them well. They want to diversify, but they’re diversifying away the very thing they want, which is excess return.” You need to focus on what you are doing and select among the ways to do it.
- “investors haven’t taken advantage of sophisticated tools and data developed in recent years to decompose various forms of risk, such as country, region, and idiosyncratic risks.” I liked their salad bar example. A little of everything or some other combination to make the perfect salad.
- “The report also found that market timing was a common and costly sin for institutions.” When things are going well, managers move to be more active. That lasts longer than the market rewards the behaviour.
- “The dynamics of the market are changing so much. What appears to be skill is often luck and that luck tends to be short-lived,” Baseball pitcher Lefty Gomez, reputedly said, “I’d rather be lucky than good.” That is not a bad choice for a given pitch but as a career-wide option, it is impossible. Your career results will depend more on skill than luck.
The moral of the story
Professional managers don’t always get it right, so you, with fewer resources, will have to work harder at it.
Pay attention to your purpose. Then decide how to get it. Diversification may work well for you, but it may be of less value than you think. When you understand markets and you understand how they interact, you may be better able to choose a portfolio that matches your requirements.
Try not to forget all the other factors that influence return and help to get you the result you want.
There are many to consider and your portfolio manager doesn’t know about you in detail. What is your tax position? How necessary is liquidity for you? Do you like exciting more than boring? Do you have special knowledge about an industry or a product? Can you meet the minimum investment number? Do you spend returns in just one currency?
There are many more.
The best portfolio is the one that rewards you for all your inputs and protects you from the ones you cannot supply. Diversification is one of the ways you can do that, but you must be careful and wise.
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I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages—the result: more security, more efficient income, larger and more liquid estates.
Please be in touch if I can help you. don@moneyfyi.com 705-927-4770
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