Understand diversification
Posted by John Reed on
Diversification in finance is not understood properly. There is no such thing as generic diversification.
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You diversify for a particular risk. For example, going from owning a rental house to owning a duplex gets you some CREDIT diversification: two tenants whom you hope will pay the rent instead of one.
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What about diversifying by buying a second rental house in an adjacent town? That gets you a little bit of MUNICIPAL LAW diversification and first CASUALTY diversification. If the first town passes rent control but not the second, you have diversified from municipal risk and you have reduced the risk that a single fire will burn down your entire portfolio, which it would when you only owned one rental house. Note that you are NOT diversified against county, state, or federal law risk or that market being overbuilt in homes.
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How about diversifying by going from one chip manufacturer stock to two. That diversifies against MANAGEMENT risk. But not chip manufacturer risk or stock market risk.
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If you invest in ten different chip manufacturers, you diversify against management in one or two corporations, but not against chip manufacturing risk. These stocks are not uncorrelated.
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“Non-correlated or uncorrelated assets are not affected by market forces in the same manner as the worth of other investments in your portfolio. Their price movements do not affect each other. These assets present unique benefits and disadvantages for investors...”
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If you own, say, ten different stocks that all sell the same product, you are diversified against management risk—some CEOs may do a lousy job. But you are NOT diversified that that particular PRODUCT CATEGORY may do badly, like buggy whips after the spread of the horseless carriage. That is also an example of OBSOLESCENCE risk. If you owned stock that made ten different products, it is not likely that more than one could go obsolete at the same time.
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Is owning an S&P 500 index fund diversification? It is diversification against variations in performance among those 500 stocks. Your return will be the average of all of them. However, it is NOT diversification against stock market risk. In the Great Depression, the average S&P 500 stock dropped 90% in value. Having 500 different stocks that all dropped 90% did not protect you from anything meaningful.
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How about you own a house and and S&P 500 index fund. Is that diversification? Yes, regarding differences in home price movement and stock movement. But in the Great Depression, BOTH the house and the S&P 500 dropped 90%.
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Since WW II, there have been times when the houses dropped but the stocks did not and vice versa. That is asset-category diversification. The great depression was actually deflation which is monetary-policy risk. In the great depression, the purchasing power of the dollar rose and the value of hard assets fell. Both real estate and corporations are hard assets.
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Get the idea? There is no generic or all-purpose diversification. Also, can you have TOO MUCH diversification? Yes. 100 top stocks is about the point of diminishing returns. Going to 500 stocks or 4,000, generally does not get you much less risk. But the administrative cost would be greater buying all those different stocks and getting rid of any that drop off the index for whatever reason.
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My main complaint about so called financial advisors is they only care about securities like stocks, bonds, and futures contracts. That to me is pretty wimpy diversification. You also need a House that you own and coins (commodities) that you own and have possession of, also inventory and/or raw materials if you have a business, foreign currency is a hedge against USD inflation and is generally uncorrelated with the other investments I recommend.
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Securities dealers will agree that my recommended portfolio give more diversification than just securities, but they do not want to get their hands dirty with anything like homes or coins or foreign exchange and if they will not get their hands dirty then they do not make money from your buying those assets. So they may leave you with the impression that you need to get ALL your diversification from them. I recommend you buy all of the assets listed above. I make no money from telling you that per se.
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I have no problem with those dealers saying we do not do homes, etc. What outrages me is if they say or imply that all you need are the assets they sell. That is Bull.
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Summary:
• Diversification gets you the average of the performance of all your assets. It does NOT protect you from LOSS. Sometimes ALL stocks or ALL homes go down at the same time in which case diversification is meaningless.
• You must enumerate all the risks you face and manage each. Diversification is a risk-management tool, but it only works on specific risks, not as a sort of general guardian angel. It is not pixie dust that you just sprinkle on your assets and get protection from every risk.
• The other ways to manage risk are to avoid it entirely, mitigate it by changing the property, insurance where not too expensive, or to hedge it which is buy assets which go up on value when other of your assets go down in value like forex hedge against USD inflation.
.
You diversify for a particular risk. For example, going from owning a rental house to owning a duplex gets you some CREDIT diversification: two tenants whom you hope will pay the rent instead of one.
.
What about diversifying by buying a second rental house in an adjacent town? That gets you a little bit of MUNICIPAL LAW diversification and first CASUALTY diversification. If the first town passes rent control but not the second, you have diversified from municipal risk and you have reduced the risk that a single fire will burn down your entire portfolio, which it would when you only owned one rental house. Note that you are NOT diversified against county, state, or federal law risk or that market being overbuilt in homes.
.
How about diversifying by going from one chip manufacturer stock to two. That diversifies against MANAGEMENT risk. But not chip manufacturer risk or stock market risk.
.
If you invest in ten different chip manufacturers, you diversify against management in one or two corporations, but not against chip manufacturing risk. These stocks are not uncorrelated.
.
“Non-correlated or uncorrelated assets are not affected by market forces in the same manner as the worth of other investments in your portfolio. Their price movements do not affect each other. These assets present unique benefits and disadvantages for investors...”
.
If you own, say, ten different stocks that all sell the same product, you are diversified against management risk—some CEOs may do a lousy job. But you are NOT diversified that that particular PRODUCT CATEGORY may do badly, like buggy whips after the spread of the horseless carriage. That is also an example of OBSOLESCENCE risk. If you owned stock that made ten different products, it is not likely that more than one could go obsolete at the same time.
.
Is owning an S&P 500 index fund diversification? It is diversification against variations in performance among those 500 stocks. Your return will be the average of all of them. However, it is NOT diversification against stock market risk. In the Great Depression, the average S&P 500 stock dropped 90% in value. Having 500 different stocks that all dropped 90% did not protect you from anything meaningful.
.
How about you own a house and and S&P 500 index fund. Is that diversification? Yes, regarding differences in home price movement and stock movement. But in the Great Depression, BOTH the house and the S&P 500 dropped 90%.
.
Since WW II, there have been times when the houses dropped but the stocks did not and vice versa. That is asset-category diversification. The great depression was actually deflation which is monetary-policy risk. In the great depression, the purchasing power of the dollar rose and the value of hard assets fell. Both real estate and corporations are hard assets.
.
Get the idea? There is no generic or all-purpose diversification. Also, can you have TOO MUCH diversification? Yes. 100 top stocks is about the point of diminishing returns. Going to 500 stocks or 4,000, generally does not get you much less risk. But the administrative cost would be greater buying all those different stocks and getting rid of any that drop off the index for whatever reason.
.
.
Securities dealers will agree that my recommended portfolio give more diversification than just securities, but they do not want to get their hands dirty with anything like homes or coins or foreign exchange and if they will not get their hands dirty then they do not make money from your buying those assets. So they may leave you with the impression that you need to get ALL your diversification from them. I recommend you buy all of the assets listed above. I make no money from telling you that per se.
.
I have no problem with those dealers saying we do not do homes, etc. What outrages me is if they say or imply that all you need are the assets they sell. That is Bull.
.
Summary:
• Diversification gets you the average of the performance of all your assets. It does NOT protect you from LOSS. Sometimes ALL stocks or ALL homes go down at the same time in which case diversification is meaningless.
• You must enumerate all the risks you face and manage each. Diversification is a risk-management tool, but it only works on specific risks, not as a sort of general guardian angel. It is not pixie dust that you just sprinkle on your assets and get protection from every risk.
• The other ways to manage risk are to avoid it entirely, mitigate it by changing the property, insurance where not too expensive, or to hedge it which is buy assets which go up on value when other of your assets go down in value like forex hedge against USD inflation.
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