Thinking Differently about Diversification

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By Acred99 (Own work) [CC BY-SA 3.0 or GFDL], via Wikimedia Commons

You want to invest, and you figure the way to do it is to (somehow) pick the best stock out there and load up. What’s the best stock out there? Right now, some people will tell you it’s Apple, some people will tell you it’s some small company in the marijuana industry, some people will tell you it’s Berkshire Hathaway, and they’ll all have their reasons why. For the sake of our discussion, it doesn’t really matter what that one stock is, let’s just pretend that you have picked your one stock and you’re going to put your money into that stock because you believe your money will be best put to use there. After all, what’s the point of diversification if you’ve picked the best stock out there? It’ll only dampen your returns, right? Well, besides the reality that you can’t predict the future, there are a host of threats your investment continuously faces. Through diversification, you can hedge your risk of investing in that one equity high-flier. Utilizing broad-based, poorly correlated assets in a well-balanced lazy portfolio minimizes your risk to each individual stock, protecting you from the possibility of an outright loss. And rest assured, there’s an immense amount of risk out there to mitigate.

Along the way, all sorts of things can happen to your darling company and its stock, some directly influencing it, some indirectly. Someone else may sue them for patent infringement. Another company may come up with a more revolutionary product, making their products less appealing. The company may lose its innovative and inventive edges. Management may change for the worse, for one reason or another. Legislation may be passed that negatively impacts growth plans or product sales.

To hedge the risks posed to your company, then, you decide to put your money into a fund that tracks the particular index that your company is in, like technology, financials, consumer goods, etc, figuring that if your company is doing well, probably others in the index are doing alright, too. You trade the outperformance that you expect your stock can deliver for the safety in numbers that investing in more than one company provides, but still, there are risks. Legislation that affects your company may impact the whole sector. Or, the sector may be subject to paradigm shifts that change the way we live or buy things – think brick-and-mortar bookstores in the face of e-books and digital reading devices. Whole sectors can be negatively affected by a host of things. Clearly OPEC letting the fuel flow is hurting the entire energy sector, at the very least. And natural disasters can send insurance company stock prices scurrying.

Given these additional risks, you decide to protect your investment in your company not with an index fund based on your company’s sector but with an index fund based on all equities, deciding that if your company or its sector face hopefully only temporary headwinds, other companies and sectors in the vast world of investing may not – they may do well when your company and its sector are not doing so hot, increasing your chances for positive return and decreasing the hit you might take if something negatively impacts your company’s equity performance or the performance of its sector.

Yet still, wouldn’t you know it, there are risks. The equities markets may face downturns for any number of reasons. Hedgefunds, with large holdings in your company and others, may collapse if they get burned by one of their bets (the recent Swiss Franc changeup, for instance). The banking system may falter as a result of derivatives trades gone wrong. Financial firms may be the victims of injurious cyber attacks. The Federal Reserve may mismanage the interest rate environment. Troubles abroad may give investors the jitters at home as everything is globalized. These things and more can bring down the domestic markets as a whole, including your company’s share price.

Hence, you decide to put a portion of your money in the broadest based international equities fund you can buy, to go along with the broadest-based domestic equities fund you can buy, to further cut your risk exposure. Somewhere in the world, you reason, there are likely to be a few countries’ companies and their corresponding equities that are doing well even if the ones at home are generally not. However, given today’s immense intertwining of financial markets around the globe, the interactions of trade and currencies and business partnerships and so on, this move only affords you a smidgeon of extra insurance as equities markets all over the world often move in tandem, i.e. if there are major problems in developed countries and their markets especially, that can bring all markets down.

So, finally, you buy bonds in order to further hedge your position in your company, its sector, your domestic equities markets, and worldwide equities markets at large. And not just any bonds, but the broadest-based bond fund you can buy, at least the US specific one anyway, to go along with the broadest-based equities funds you can buy. The performance of bonds is generally poorly correlated with the performance of equities, meaning that bonds tend to go up when equities are going down due to flight-to-safety responses on the part of investors (vice versa, when bonds are going down and equities are going up, it is said that market participants have an increased appetite for risk). At this point, you’ve finally diversified as much as many passive and lazy investment practitioners might recommend, and some would argue you’ve protected your initial investment in your favored darling company as much as anyone can expect to.

Is there more you can do? Sure. Studies have shown, for instance, that a relatively small investment in a commodities fund or in gold in particular is worthwhile as the performance of these assets tend to be poorly correlated with stocks and bonds, giving you added protection and return potential. Others would say that the benefits are marginal at best. What experts would not deny is the powerful risk mitigation of the broad-based equities/bonds combination, although many continue to chase the dragon in their pursuit of outperforming the market. However, that’s gambling, not investing, and a subject for another time.

Hence, what have you now accomplished? You are invested in your favorite company but you are also invested in many others as well as bonds, and this helps you protect your original investment. Don’t think of lazy or passive investing as the slow path to your goals, think of it as the sound path to your goals; think of it as the most secure way of hedging your risk of investing in those top individual companies out there.

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