Diversification Is Your Only Friend

How many times must this lesson be learned? Apparently there's no limit when it comes to naïve and overconfident investors, which is to say that the need for tutoring is vast and unending. Sad and frustrating, but still true.

Two examples from today's papers remind once more that diversification is too often ignored, assuming it's recognized at all. Chalk it up to greed and fear, and perhaps ignorance of sound investment strategy. Good financial planning advice is widely available, but that doesn't stop self-destructive behavior in finance, even in the center of the financial universe.

In today's New York Times, for instance, a story about the fallout from the collapsing Lehman Brothers —  a 157-year-old Wall Street investment bank — quotes a "rank and file employee" of the stressed company as it relates to the person's investments. This former Lehman worker, who left the firm earlier this year, "lamented that he had put enough faith in the firm to retain shares — a decision he is paying for. 'My children’s education fund is wiped out,' said this person."

One might imagine that working on Wall Street would provide some exposure to the lessons of sound portfolio strategy that have been honed over the last 50 years, but one can never assume when it comes to money.

Another sad item comes today via The Wall Street Journal, which relates the tale of a man who apparently invested all or at least most of his sons' college money in Freddie Mac (FRE)shares last week. The government has since taken over the battered mortgage institution and the shares have dropped sharply, leaving the investor's college fund virtually wiped out.

The lesson, of course, is that diversification is your only friend. That truism is only rarely on display, such as the two instances above demonstrate. But please don't confuse frequency of value with general necessity. Most of the time diversification, along with fire insurance and a sturdy roof, are taken for granted. That leads some to fall into the trap of thinking, especially after a long stretch of good fortune, that neither are relevant after all.

Similarly dim views are known to harass diversification, which usually pales in comparison to betting the ranch on a more narrowly focused investment notion. A few lucky or skillful investors can turn those odds in their favor and break the rules and cash in on easy profits. For the rest of us, a prudent approach to portfolio strategy is still the only game in town, even though it appears otherwise 98% of the time. Risk management, to be precise, is too important to ignore, as we've discussed many times over the years, including here and here.

Even so, the value of risk management is rarely obvious, save for extraordinary moments in the cycle -- like now. The prudence of risk management is unrelated to how often it's useful. It's primarily a strategy minimizing the odds of insolvency. Sometimes winning on that front just once makes all the difference. Indeed, for most of us, we won't have a second chance to accumulate a lifetime of savings. 'Nuff said.

Comments

[Larry House:]

Thanks for this oft-stated point, but it is not the end-all truth. Diversification may be your friend, but it can't always protect you either. A lot of investors are well diversified right now and are still getting crushed. Also, the single most important consideration when beginning to invest is not diversification--it is THE INVESTOR'S POINT IN HIS OR HER LIFE. That dictates what assest allocation and diversification plan makes sense.

2008 Sep 12 04:10 PM

[Agcapita:]

Difficult to obtain diversification in a market with high postive correlations between virtually all asset classes. This is a very unusual state of affairs. There are very few uncorrelated assets classes accessible to the average investor. For example, timberland and farmland have small negative correlations to stocks and fairly high correlations to inflation - might be something to consider going forward in a market with a federal government dedicated to inflating the currency away. The challenge becomes how to cost effectively deploy capital in these areas.

2008 Sep 12 04:53 PM

[mwright:]

Diversification has not worked well recently because extreme debt problems forced many to sell anything and everything. The baby with the bath, emerging markets with Treasuries . . . and all prices dived more or less together.

2008 Sep 12 05:47 PM

[WEBISKING:]

I have had 75% of my net woirth in one stock for 10 years now altria.Go fgure out its return with reinvested dividends since 2000 when the PE was 7

2008 Sep 12 07:49 PM

[HumbleBee:]

THis article is not bad.
However, for an average investor, one should be reminded to withdraw from the market once in a while to conserve capital.
Just get out! Forget diversification. This market is too tough for common folks!

2008 Sep 13 08:58 AM

[cocomurph:]

With all due respect, HumbleBee, if one has a long-enough investing time frame, I would suggest the Warren Buffet approach...buy the good companies when they are cheap versus getting out of the market. No, all of your purchases will not be exactly at the bottom, but over time, times like these are the very best times to establish positions in great companies that get punished along with the not so great ones. An added bonus is that you avoid the tax bill of constantly entering and exiting the market

2008 Sep 13 10:38 AM

[cynic69:]

Diversification is an incredibly stupid idea that is guaranteed to make you poor and your broker rich. The idea that if you own a set of stocks and you have security because some stocks go up and some go down is illogical because 90% of stocks follow the major averages. Even if it worked it only means that you don't lose much but you never have any real profits.

2008 Sep 13 11:24 AM

[henarl:]

Hublebee & Wakeup: If you take part of your money out of the market, that IS diversification - you have diversified partially into cash. However, if you take ALL of your money out of the market, where do you put it now ?
Bank or money market interest is considerably below the real inflation rate so you are losing buying power over the long haul.

2008 Sep 13 02:51 PM

[Roger Nusbaum:]

Webisking, you have taken the exact same risk spelled out in the article. the only difference is you have not had to confront the consequence of that risk.

Was your entry point 2005? You might have been shaken out earlier in the decade when the lawsuit news was causing the most damage, or maybe not but the stock got crushed back then.

Altria is a client holding.

2008 Sep 13 04:46 PM

[oldman:]

nothing has worked except cash, bonds, CD's. Diversification is another word for not sure where to be.

2008 Sep 13 09:46 PM

[michael fro...:]

diversification....and some patience....and ability to add to your positions, whether it's stocks, bonds, cd's, or cash....is the way to go. sorry to hear nothing has worked for you Oldman....i've taken some profits and some losses this year. i haven't learned how to use options yet...still working out the kinks in my strategies. i say strategies because you have to play this game with many, not just one way....educate yourself, plenty of books out there, plenty of websites too.

2008 Sep 14 02:12 AM

[venividivici:]

The most common advice given by so called "experts" it always to diversify. And it's fabulous advice if you want to be poor and stay poor. Diversification is a great strategy for those who don't know what they are doing. Warren Buffet, by the way agrees. There's nothing wrong with putting all your eggs in one basket but you have to know what you're doing and you have to watch that basket very carefully because things can always go wrong.
I had five great years trading the market up until August last year by picking one or two stocks I liked and then going in with everything I had. But I left the market in August because I could see the dangers that lay ahead and they have got infinitely worse since then. As for diversification, even that won't save you from losing a lot of money in this market.

2008 Sep 14 03:21 AM

[Did U Think...:]

Now hear this: the entire stock market is a Ponzi scheme. What you make on average in returns is taken out the back door by inflation and taxes. It is a sucker's game at best. If you had just bought gold when it was legalized in the 1970s you would have done as well or better than any asset class without the risk of companies going BK because gold can never BK.

Stock markets do not create wealth they just move it from person to person. The only reasons that funds and institutions ever did any better than average people is that they consistently traded on insider information. But this gets harder and harder in the Internet age and so funds are in big trouble. Also, a big block of boomers will soon stop panic saving into their 401s and instead start pulling funds out. Since the whole thing is a Ponzi scheme which requires a greater fool to come along and buy the stock from you so that you can profit, soon there will be no profit to be had because the buyers will dry up with the retiring boomers.

The only diversification possible in this market is from shit sandwich to douchebag. The stock market is win-lose. For every winner someone has to lose. Of course, the banks always win as they make money on trading fees and collect interest on margin loans.

Here's the best diversification strategy of all: diversify away from being "long" any stock into "owning" short positions and puts. This is the only clear winner for AT LEAST 2 years if not for the next 5-7 years.

2008 Sep 14 05:43 AM

[henarl:]

WAKEUP: Ah, now you are talking about active investment - running a business, not passive investment in the markets. I agree that the very best way to make money is in your own business. That's how I actually made the money that I'm now trying to just keep in an era of market deflation and dollar inflation. I'm now 78 years old and, hopefully, retired from the daily stress of running a business so passive investment is my concern - and the subject of this discussion.

2008 Sep 14 12:31 PM