Could we both agree on the following notion?
That, in the investment field, there is no one instrument that can perform all the time, and that there is no one who can say with certainty—in advance—which instrument would perform best. The future is uncertain and markets are random.
As such, what Harry Markowitz demonstrated mathematically in 1952 still holds true: Putting all of one’s eggs in one basket is an unacceptably risky strategy, and diversification is the closest an investor can get to having a free lunch.
Personally, when I’m in doubt, I always remind myself that I am an investor, not an entrepreneur. There’s no need for me to put all my eggs in one basket.
My aim is to diversify across investment baskets—with many eggs in each—so that I will not be “done in” by any one event.
Real and strong diversification, however, isn’t achieved by looking at asset class correlation data, but rather through an understanding of how certain assets respond to changing economic conditions.
Basket 1: Blue Chips and ETFs listed in my home country (never more than 30 positions—to avoid diworsification).
Basket 2: I do have some assets outside my home country (to avoid the home bias). Geographical diversification is necessary as many of our assets solely depend on how well our home country does. Like our largest asset, our earning power—if we work in our home country and aren’t prepared to relocate when the economy hits a bump. And the value of our home, or the value of our investment property (when applicable would be another “Basket”).
Real diversification is certainly not achieved by owning some blue chips, some growth stocks, some penny stocks, some REITs, some government bonds, and some corporate bonds all listed in the same country!
Not even if you have some stocks in your portfolio whose businesses are regional and mainly derived from outside your home country. Don’t you agree that their stock prices would be closer correlated to the sentiment of the local stock market they are listed in, rather than to the sum of the sentiments of all the regional stock markets they have business in?
Basket 3: Non-paper currency assets. I want to own something that is detached from the currency of the country I live in. Because paper currencies are extremely unstable. They might appear stable in the short term, but they really are not in the long run.
Gold and Silver (physically and in my possession) is an ideal asset class for making a portion of my life savings immune from political antics and currency emergencies. Having gold in my portfolio works in the long run and I currently don’t even lose much opportunity costs, as Cash/Fixed Deposits earns me zero or negative real returns.
Basket 4: Alternative asset classes with diversified strategy
The more sophisticated investor chooses alternatives that are both diversified in asset class and in strategy.
This means diversifying away from all buy and hold strategies in your portfolio and exploring trading models that do not require underlying asset appreciation to make you money, such as:
- Shorting Stocks or ETFs
- Selling Stock Options
- Private Equity
- Hedge Funds
Real diversification means investments that can potentially offer returns regardless of what is happening to asset prices, the economy, or the world.
It doesn’t mean they’ll perform all the time in every circumstance. But they can perform, sometimes very well, in environments where more traditional investments won’t. And that feature (not only does it help protect my portfolio) can help boost my overall returns.
Let’s see how the above examples stack up in that regard:
Shorting Stocks or ETFs: Diversified in strategy, but not in asset class. Doesn’t meet both criteria. Deep Out-Of-The-Money (OTM) put options are however a good hedge against Black Swan Events. (It provides me with peace of mind)
Selling Stock Options: Good way to diversify strategy, but it doesn’t meet diversification of asset class requirement. (Keep in view)
Private Equity: Could potentially meet both criteria; however, depending on what’s being funded, could be affected by the same factors that affect stock prices. Requires a substantial amount of expertise to find the right company in the right niche that’s not overvalued yet. (I have embarked on this recently)
Hedge Funds: May or may not be diversified in strategy or in asset class. Be aware that many hedge fund managers are just stock pickers with a different title. And hedge funds require much due diligence in identifying strategy, asset classes traded, and the experience of the manager. (Not for me, at this point of time)
Additionally, be wary if an “alternative” asset class costs a lot more to own than traditional categories going into the other baskets—it probably won’t turn out to have durable value.
Traditional models of what passes for diversification don’t always serve my best interests. In the current age of investing, smart diversification is critical when it comes to protecting against our ignorance and growing our wealth.
Real diversification means building an “all weather portfolio” and the assets to collect in such a portfolio are the ones that offer diversification of asset class or some diversification of strategy. The ideal diversifier is one that can offer both.
Real diversification helps me towards my top priority: to avoid big losses. Because as soon as I experience those big losses, I’m afraid my emotions would lead me to abandon the strategy at the worst possible time, right at the market bottom, when I shouldn’t be doing anything (except buying more).
Real diversification means lowering the risk of bad decisions. Because when the stock markets crash, I’m always going to have another asset going up in value to calm my nerves. This reduces investing stress that can help me to maintain optimal investor behaviour—which typically helps returns.
Do join me in checking our portfolios’ real diversity levels at the end of this year. Or share with us your “diversification-secrets”.
IMPORTANT: Whenever you’re in doubt about any asset class, err on the side of safety. Don’t do it. If you are unsure of an investment, give it up. An opportunity missed is better than capital lost.
“Diversification reduces risk, increases predictability, and boosts returns.” — Robert Brokamp