Diversification and Potatoes

Dear Clients and Friends,

In the book, 1493: Uncovering the New World Columbus Created, author Charles Mann recounts the story of the first Europeans (mainly Spaniards) finding a new crop we today call the potato.  Out of the 7 or so potatoes varieties that were farmed in the New World, only a few varietals were brought back to the Old World and one in particular, the white potato was grown for mass consumption.  Eventually the lack of diversity mixed with a potato disease (blight), created a massive famine to the continent circa 1845 in what is today called, “The Irish Potato Famine”.  In fact, the famine was most acute in Ireland where it claimed 1 million lives over a 4-year period, yet most of Europe suffered white potato blight and varying degrees of famine.  What the New World Natives knew, the Europeans found out; which is- you don’t plant and cultivate just one potato.

The Irish people became very dependent upon one single potato plant to be a staple food source.  Who can blame then, the potato is an amazing food- it is packed with Vitamin C, potassium, B6 etc.?  When you combine the lack of genetic variability with a disease that traveled from Mexico to the Old World, (most likely through transatlantic trade), you get a crop failure.  Diversification works much the same way, when you own assets that respond to the same risk, you eventually get a crash.  The Natives in the New World were acutely aware of the risk of potato crop failures, and they relied upon the diversification of potato crops to defend against this event.  The Europeans just knew they had something really special, but they hadn’t yet experienced the risk.

When investors look at the market today, they have to ask, why not just own the stocks that are going up?  Many market pundits have described Diversification with the term, “Diworsification”, eluding to the fact that diversified portfolios have chronically underperformed the averages over the last decade.  In my experience, the idea of diversification is easy to follow when things are bad, but difficult to stomach when things are good.  Who wants to hear about the benefits of diversification when they have watched everyone get rich on tech stocks?  Harry Markowitz, the father of modern portfolio theory described Diversification as a “free lunch”, but he failed to mention the bitter taste that free lunch sometimes presented.

Catastrophic losses in our markets are rare, but not as rare as one would expect.  Those alive in 1929 and the 1930s would have been keenly aware of the loss one could take by placing their ‘safe money’ in a bank.  Homeowners that invested into property are hyper-aware of the depreciation of value they sustained in the Housing Crises of 2008.  And for those who owned tech stocks in the late 90s, it took almost 15 years for the market to return to it’s all time high set in 2000.  The reason the Natives grew multiple types of potato is the same reason investors seek out assets that have differing risks. Diversification works, not because it produces the best results at any given time, but rather it keeps unforeseen risks from producing catastrophic results.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The information is not intended as a solicitation or an offer to buy or sell any security referred to herein.

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