How Diversification Tries to Work
My last blog gave 23 investing risks and tips on how to minimize those risks. The overriding tip was diversification, so I want to elaborate on that here and in my next blog. Diversification is a method of spreading, offsetting or hedging risk. This means that you do not have a high percentage of your total assets concentrated in one type of investment.
A blog providing an analysis showing the importance of diversification was posted on Jan 22, 2014 whichgave the range of gains and losses for the DJIA components over a 14-year period. That is a good starting point to understand the importance of diversification, but, there is more to consider.
Diversifying can reduce risk and losses, but it can also reduce gains. Here is an example: Assume equal investments in two stocks where one goes up 2% and the other goes up 30% providing a 16% average. That is pretty good – actually very good. However, suppose those stocks went down 2% and 30% giving an average negative return of 16%. That would be pretty bad. Without the two stock “diversification” and if the stock with the 30% change was the only stock invested in, you could have suffered a devastating 30% loss rather than a pretty bad 16% loss. This indicates the importance of spreading risk by owning multiple stocks.
On an entire portfolio basis, one way of offsetting, reducing or mitigating losses would be to find investments that would go up when others drop. The choices could be between stocks, bank certificates of deposit, bonds, and possibly commodities, real estate or alternative investments.
Now, we have some fallacies to this. To be a true hedge or to provide meaningful diversification there would need to be offsetting amounts. That means that if half are in one type of investment, the other half should be in the other; alternatively if a portion would experience a loss of a certain dollar amount, then another portion or portions would have to have dollar gains of that same amount. In most cases, this might cause much too much of an asset class exposure in your portfolio. An alternative could be to come up with ten or twelve offsetting types of investments so not too much would be in any one class, so large changes in one or two would not greatly affect the overall portfolio performance. In reality, if 10% of your portfolio increases or decreases 10%, the effect on the entire portfolio is only 1%.
Another thought is that when markets crash they tend to bring everything down together. That happened in 2008-2009. While every stock market sector, style and index tanked and U.S. Treasuries increased, many corporate bonds also went down (and as I’ve previously written, the Treasury increases were illusory). Also, for the hedge to work, you might have needed to start out with a larger proportion in bonds than stocks, which over long periods would create a drag for those looking for long term growth (which has occurred).
Keep in mind that at the end of the day, true diversification, if it can be found, will have everything moving toward the mean with a high degree of portfolio safety but also with a very low cash flow and growth. Because of this, I do not think of diversification in the sense of how most people consider it is workable. My next blog will offer some suggestions.
