The Beauty Of Diversity

by: Robert Mattei

Summary

Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1 - Warren Buffett.

Rule No. 1 becomes even more important as you approach or enter retirement.

Diversity is not a great way to get rich quick, but it is a great way to keep from becoming poor.

My ego doesn't require that I beat the market. I'm not that into measuring myself against the best. In fact, when I use to both run and play chess, my goal was to be a better runner than the chess players and a better chess player than the runners. Being pretty good is good enough for me. My goal for retirement is not to be rich; it is to not be poor.

The first rule of not being poor is to protect what you have, and diversification is one of the best tools available to do that.

If you want to get rich quick, a concentrated portfolio of a few stocks is the way to do it. I know people who have done this. It's much easier to pick a few stocks that do well than it is to pick a large number of stocks that do well, and if you start adding bonds, your chances of getting rich quick are smaller. On the other hand, the people I know who made money with concentrated portfolios were more lucky than good, and I know at least as many people that took a bath betting on concentrated portfolios.

I'll let Peter Lynch worry about diworsification and Warren Buffett can stay in the batter's box waiting for the perfect pitch. We have different goals and I think maybe those guys are a little better at investing than I am. Though I bet I can outrun them -- well Warren for sure, he's 84 and drinks Cherry Coke all day and my knees are not that arthritic.

Diversification: An Overview

In sports, players at different positions all contribute their different skills to the success of the team. If you have a lineup consisting of only hard-hitting first basemen, your team is likely to score a lot of runs. However, when you have a first baseman playing shortstop, you're also going to make a lot of errors and give those runs back. You probably want players who are skilled at positions other than first base.

When investing, you also want players that can play different positions. Different investments do well in different economic environments. In a previous article, I discussed Harry Browne's permanent portfolio. The economic conditions that Harry identified and the assets he selected to deal with them are:

  • Prosperity - Stocks
  • Deflation - Long Bonds
  • Inflation - Gold
  • Recession - Cash

The permanent portfolio has an enviable record of avoiding large drawdowns.

The concept is simple, but very powerful. Consider the major economic conditions and insure that you have assets to deal with each of them. We may not be totally on board with some of Harry Browne's asset selections and proportions, but that should not deter us from considering the core idea.

Avoiding Large Drawdowns

When I was younger and had less money to invest, it was easy to take risks. I was only risking a few years' worth of savings, retirement was far in the future and I was looking to grow my portfolio. Now growing my portfolio is still a goal, but I have a lot more invested, and not losing what I have has become much more important.

When you are in the accumulation phase, a market correction can be a benefit, as it allows you to purchase assets at discounted prices. In the withdrawal phase, the math works against you as the losses are compounded by your withdrawals. If you were unfortunate enough to have retired in the year 2000 and you were 100% invested in the S&P 500 and were making withdrawals following the 4% rule, your first decade of retirement would have looked like this:

Source PortfolioVisualizer.com

After 2009 the market bounced back nicely, but do you want to count on that happening every time? Investors in the US equity markets have been spoiled. The US has been one of the best-performing markets in the word for the last 150 years or so. There is no guarantee that it will continue to be in the future.

The US market has had negative total returns for periods lasting longer than a decade on a number of occasions. Markets in other developed nations have sustained much longer periods of negative returns, with Japan being the poster child; the Nikkei is still almost 50% below its 1989 high. Yes, it is a different country in different circumstances, but it would not take a correction nearly that severe or long-lasting to derail most retirements. Looking at only the history of the US equity market, especially if you only look at recent history and ignore periods like the great depression and the 1960s and 1970s, paints a picture of equity returns that is too optimistic.

It is imperative for most retirees that they avoid large drawdowns, and one of the best ways to do that is to diversify.

Putting Together a Diversified Portfolio

Concentrating on asset correlation can be misleading because correlations change over time. I think Harry Browne had it right, selecting asset classes based on economic conditions. My portfolio has different assets and different allocations, but the core idea is the same.

The economic conditions that I consider and the assets I believe will perform best are:

Prosperity - Equities

Recession/Deflation - Long Bonds, I prefer Treasury Bonds.

Inflation - Treasury Protected Securities and US and Foreign Equities, Real Estate.

Stagflation/Fear- Gold, Treasury Protected Securities

When the economy is rolling along, earnings, dividends and stock prices rise. Equities are the place to be, but not all parts of the world will participate equally, and it is possible for some world markets do poorly while others are doing well. Diversifying into foreign markets insures that my equity investments will always include some of the better performing markets. The same logic applies to being invested across sectors and market caps. Under various economic conditions, stocks in different sectors and with different market caps will perform differently.

During a recession, inflation usually falls; when it falls into negative territory, it is deflation. In either case, falling inflation usually means falling interest rates and long bonds benefit.

Treasury protected securities pay a set interest rate and the principal is adjusted for inflation. The principals will never be adjusted below the amount paid for the bond. This makes them a low risk inflation hedge. Inflation by definition means real asset prices are rising; real estate is a real asset and has the added bonus of being a productive asset, so I prefer it to other real assets like commodities. During bouts of inflation, stocks don't always keep up, but they usually do better than other investments like cash and nominal bonds.

Stagflation, no or slow growth accompanied by inflation, is particularly difficult to deal with. Treasury protected securities should perform well during stagflation, but they have not been around long enough to know for sure. Gold did very well during the stagflation of the 70s and usually does well when investors are especially fearful.

There is a lot of flexibility when deciding how to diversify your portfolio and you may want to consider other assets like your home, rental properties or even social security. No matter how you do it, you should focus on the different economic environments and the asset classes that will do best in each.

Seeing is Believing

To show how a balanced portfolio can limit drawdowns and protect retirees during the withdrawal phase, below we compare the performance of Bill Schultheis' Coffee House Portfolio and Harry Browne's Permanent Portfolio to the S&P 500. Again, we assume a retiree is following the 4% rule and we use the period between 2000-2009:

Conclusions

Rule 1 in retirement is don't lose money, or at a minimum, avoid large drawdowns. Large drawdowns early in retirement can derail a retirement. Diversity lowers the risk of all of a retiree's investment assets underperforming at once, which helps limit losses.

Select a team of investments that does well in different market environments. Each investment has its strengths and weaknesses, but working together, they can cover for each other's weaknesses and help ensure retirement success.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.