Thinking About Diversification

If you take into consideration the cost of sleeping pills and mood-altering drugs, diversification produces higher yields than active management. A well-diversified portfolio is soothing. Boring even. Boring is an important investment goal many overlook.

The purpose of diversifying

The stock market operates around a clear yield signal. Over a hundred years and more, it earns roughly 9.5% before fees and costs. The problem for most of us is it doesn’t earn 9.5% every year. There are some pretty exciting pieces, but the long run is clear. You might ask if you are not investing for the long run, can you recall yourself an investor? Maybe a trader.

Some moves are spectacular and we enjoy those. Some are dismal and we are fearful. As Daniel Kahneman points out, we dislike losses twice as much as we like wins. That means we tend to change our plan when things go badly and then miss the win that follows.

Diversifying is the plan to limit the dismal years at the price of limiting the spectacular ones. The clear aim is to prevent the poorly timed sale.

How diversifying works

Not every security follows the same track as every other one. For example, while energy stocks are down, pharmaceuticals may be up. If you own both, you won’t get the maximum possible gain, but you will suffer smaller losses too.

Most people don’t quite see that effect, but they can see the undiversified problem. Suppose you won two stocks. One of them is a steel company and the other manufactures cars. When car sales are good, steel sales are good, too. Big wins on both parts of the portfolio. I like that, but what happens when car sales are down? Bad, bad, bad! The problem is one mathematicians call positive correlation. When one moves the other does too, and in roughly the same amount. A portfolio might affect your zen better if it was less volatile.

Investment risk is measured by volatility, and you reduce it by imposing assets into your portfolio that negatively correlate with other pieces. Our intuitive idea of risk is a little different. Investment risk requires two conditions—a loss in value and the need to access the money on that day. Absent the access, the risk is different. Liquidity is a hedge against need, and cash is part of a diversified portfolio.

You reduce volatility in the invested part s of the portfolio by injecting assets that are negatively correlated to the markets you are investing in. Government bonds are a common choice. Their correlation coefficient is roughly minus .35. They will tend to stay or go up as other assets fall. Gold and silver might work too.

Think of diversifying with low yield assets as paying an insurance premium that keeps you from emotional action.

Overcoming your humanity

It’s hard to overcome humanity, so you build systemic defences. Thus diversification.

How you tell when to pay attention. A fund manager I know claims people are as emotionally distraught when making super-normal gains as when losing. Greed replaces fear. His advice, “Sell until you sleep.”

It takes a little thought to get it close to right, but most balanced funds can get you into the arena. You may want to understand how they spread the risk around and learn from that. Some are not as truly balanced as you would think. Many are a large-cap equity fund and a government bond fund in one package. You could do that yourself with a lower MER.

International diversity is harder yet. One thing we intuitively take for granted is that stock markets are mostly honest and efficient. Neither of those assumptions is necessarily valid outside North America and Europe. Especially notice the capitalization. That affects liquidity. By market value in 2019, the New York Stock Exchange and Nasdaq had a combined capitalization of more than $33 trillion. A popular foreign investment area is Taiwan. The total capitalization of its exchange is less than 3% of the US exchanges. There are American investment firms, like Blackrock, that control more money than the entire Taiwan stock market. If you like risk, how about Moscow. less than 2% as big. Maybe Mexico at 1.5%. Viet Nam looks interesting but at $37 billion US dollars. Michael Dell is worth more. Not so easy to assess.

The takeaway

We’re human. Systemic solutions to emotional problems are necessary.

Be discerning when assessing your choices. Don’t apply local knowledge to distant situations.

Have someone help you. Their vision will be different than yours, and that is a form of diversification too.

Know your timeline. Urgency is always in the present.

I help business owners and professionals understand and manage risk and other financial issues. To help them achieve their goals, I use tax efficiencies and design advantages to acquire more efficient income and larger, more liquid estates.

Please be in touch if I can help you. 705-927-4770

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