Dear Clients and Friends,
One of the most important concepts in investing is the idea that a well-diversified portfolio will give the investor something like a ‘free lunch’: Maximum reward for a given level of risk. But the concept of diversification begs this question: If we achieve diversification by owning both the winners and the losers, they why not just own the winners? And, in 2008, when I needed diversification the most, why did it completely failed investors?
Diversification is not a new concept, in the book of Ecclesiastes (11:2), written around 935 BC it is written, “but divide your investments among many places, for you do not know what risks lie ahead”. What was true then is true today, and what was gained through experience and culture three thousand years ago, is today a mathematical science. It wasn’t until the 1950s that strong statistical analysis started to give investors solid mathematical evidence to support diversification. Since that time the world of finance has used the principles of diversification to lend more money, take less risk, and ultimately make more money, than at any time in recorded history. In 2008 we found that there are limits to diversification, in times of crises the rules for investing revert back to something less mathematical and something more primal. As Buffet once said, “Cash and courage in times of crises is priceless.”
Diversification may also have limits, and in the future might look a bit different that it does in today’s market. A few generations ago, diversification may have meant owning a couple of rental properties and a portfolio of stock and bonds. Before that it may have meant owning a few farms, timber or precious metals (tangibles). Today, diversification can still mean owning farms, gold and real estate but for more and more people it is the ownership of stocks, bonds and funds (intangibles). So, the ‘tangibles’ have given way to the ‘intangibles’, and one of the consequences of this is the removal of understanding what we own. In the world of tangible investments, the risks were somewhat obvious; a house burns down, a farm floods, a theft of gold etc. With an investment portfolio consisting of thousands of stocks and bonds, the risks are only clear when they result in permanent losses.
With risk comes reward. The two are simply linked at the hip, you can’t have one without the other. Which brings us to the answer to the entire question on diversification: Diversification is best way to achieve the goal of taking the acceptable level of risk to achieve a certain rate of return. So, it starts with the risk one is willing to take and moves forward. Sticking to the strategy is an essential part of the strategy, and is most likely to be questioned when the markets are either really good or really bad. George Patton had something to say about sticking to the strategy, “The time to take counsel of your fears is before an important battle decision…When you have collected all the facts and fears and made your decision, turn off all your fears and go ahead!”
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All investing involves risks including loss of principal. No strategy assures success or protects against losses.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.