Sunday, April 4, 2010

Pros and Cons of Diversification

The New York Stock Exchange on Wall Street, Ne... New York Stock Exchange, Image via Wikipedia
Diversification is a risk management technique, that mixes a wide variety of investments within a portfolio. The idea is summarized by the adage: don't put all your eggs in one basket.

The problem is, most people are doing it wrong. Either they are NOT diversified when they think they are, or they think diversification will minimize their risk, when it does not, because they don't really understand what they are giving up when they diversify.

Let me give you an example: Say you have a dozen eggs. You decided to put each in one basket on the table. Now you have a dozen baskets, each with one egg. You are diversified, yes, as one basket tipping over will not ruin all of your eggs. Right?

Right, until someone tip over the whole table.

When the economy went into a recession, all baskets on the table are affected. No amount of diversification will save you, if you leave everything on the table.

Most people, when they hear the word diversification, they think investing in stocks of different sectors... If you remember the 6 stock archetypes from earlier, they'll put some in fast grower, and some in stalwarts, with some risky stuff in cyclical, turnaround, and maybe asset play. The really safe ones may put some in bonds and mutual funds. The problem is... These are all PAPER ASSETS. What's worse, mutual funds are just "diversified" stock investments: the fund manager invests in a bunch of different stocks. So investing in diversified stocks and investing in a mutual fund is the same thing. Also, while the bond market usually moves opposite that of the stock market, it does NOT always do so. Thus, relying on it always do so is rather foolish. Therefore, investing in all paper assets is NOT diversification.

True diversification involves non-paper assets, such as real estate, commodities and precious metals and such. Why? Let me illustrate:

Imagine the same dozen eggs, except you put some of the baskets on the ground, away from the table. Now, even if you tip over the table, unless the table falls right on top of the baskets on the ground, you should still have some eggs left. Now that is true diversification. The idea is to put your money in a completely SEPARATE market, something that is NOT based purely upon the economy, for TRUE diversification.

While the real estate prices have dropped due to foreclosures and such, rental properties are far less affected because their prices are far more reliant upon cashflow than other factors, such as market pressure. Think of it this way: when in a buyer's market, a normal family house's price will drop, until someone thinks the price is worth buying, right? But that's a liability, takes money OUT of buyer's pocket every month due to a mortgage. A RENTAL property, on the other hand, produces monthly cashflow, and that is worth a lot MORE than a regular house with a mortgage. A rental property, even if it's just a family house, but with a tenant paying the rent, is worth more than the same house withOUT a tenant, to an investor. On the other hand, you must realize that investment properties usually do NOT qualify for a loan modification, as many are no doubt finding out now. If you do not want to take that kind of risk, you can invest in real estate trusts instead of directly buying real estate. But you may not enjoy as high a return.

When economy goes bad, people flock to precious metals. In times of war or disaster, people buy gold or silver. When WW2 begin (which for China, start with the Japanese invasion of Lu-Go Bridge, years before Hitler invaded Poland), refugees bought up gold and silver and carried them instead of possessions. Jews fleeing Europe from Nazi persecution brought gold and silver. Precious metals are portable, and valuable almost everywhere. Those have intrinsic value to almost everybody on Earth, thus is far less affected by the economy. They are not paper assets, but real assets. And you don't need to actually have them shipped to you. Instead, you can just trade in gold and silver certificates, and pay a small annual fee to insure and store them elsewhere. On the other hand, people pushing gold or silver as the hedge against economical downturn like the one we have now are not exactly being completely honest. However, that is story for another observation.

Now, what exactly do you give up when you diversify? You give up a lot of profitability, and just SOME of the risk.

Let's say you have a very diversified portfolio... You own each of the 500 stocks in the S&P 500. Do you see what will happen? You have the S&P 500 index fund. Your portfolio will perform exactly like the S&P 500... you can't go above it or below it. You perform exactly as the market. (assuming for a moment that S&P 500 is your market, I know there's NYSE, NASDAQ, etc.)

Owning MORE stocks than the index would expose you to additional risk. Thus, to outperform the market, you MUST own LESS stocks. You MUST PICK AND CHOOSE.

Warren Buffet has said it before: diversification is for the ignorant. In other words, diversification is the shotgun approach. You can't aim, so you use a shotgun and hope to score some SMALL hits, and probably STILL misses all the time. Real investors invest in stocks they analyzed and know they are buying it cheap. In other words, they study the target, learn to lead the target, and score bullseyes more often than they miss.

You also give up the gains by having other stocks to weight it down.

Let's say you have 10000 and you invest in 4 stocks, A, B, C, and D equally, 2500 each. let's say C went up 100%, is now worth double. So your portfolio now is worth 12500, correct? Let's assume the other three had went sideways (no change). That is a slightly diversified portfolio.

What if you have the same 10000, but you decided to pick C because you have studied it and you are quite cetain it will double? You will now have 20000 (100% return). That is certainly NOT a diversified portfolio.

A difference of 7500, out of 10000 invested. 75% difference in return. That's the price you pay for "security", because you didn't trust yourself to commit 100% to stock C, but instead decided to hedge your bets on A, B, and D as well.

So what exactly do you gain with diversification? The idea is you lose less. To use the same scenario, but instead of C goin up 100%, say C went down 50%.

If you have a "diversified" portfolio, you'd end up with 7500+1250= 8750. Your portfolio is down 12.5%.

If you have just C, you'd end up with 5000 (half of 10000). Your total value is down 50%

In other words, diversification is supposed to smooth out your investment... both upward spikes, AND downward spikes. In other words, in order to limit the potential losses, you've also limited your potential gains.

Frankly, if you have NO IDEA which of these four are undervalued, and thus worth buying, then perhaps you should not have bought any of them. There should have been some sign that company C is fundamentally sound and undervalued, thus is worthy of your investment.

Have you considered WHY Wall Street recommends diversification? Simple... They want your money

* the more complicated the process is, the less likely you'll understand it, thus hoping that you will leave it to them
* the brokers make money on EVERY transaction you make. Thus the more transactions you make, the more they make
* and frankly, they are all taught by the same schools, so no wonder they give the same advice

Mutual funds are even worse. You give up ALL control over the money, hoping that the fund manager knows what he's doing. Some, of course, really do know what they are doing, but you have to keep in mind: a fund manager is an EMPLOYEE. He makes his salary no matter what (obviously if he does pretty badly, he may not keep his position as a fund manager too long, but YOU are the one suffering the losses, not him). Not to mention there's all sorts of fees and such in a mutual fund that they can charge to lower your real gains. What's worse, mutual funds are REQUIRED by the SEC to diversify. They cannot dedicate more than 5% of their fund to own a single company's stocks. (in other words, they HAVE TO invest in at least 20 different stocks), and they cannot own more than 10% of a company's outstanding shares. In other words, they are required by SEC to invest in a LOT of different companies, so the small investors, i.e. those of us with less than a million dollar to invest, can't lose too much.

Diversification is a risk management technique for investing. However, as we have examined previously, you give up a LOT for that safety cushion. It has its uses, but you should NOT rely on it solely to manage your risk. There are ways to manage your risk besides diversification that have far less disadvantages. The problem basically is you have to do more research and work on your part, where as in diversification, you simply spread the money around and that's it. It requires no brainpower. Unfortunately, that's how average people invest, and if you want to be rich, you have to unlearn those habits.
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