Putting all investments in one basket is recipe for disaster

No investment is risk-free, but all investments are safe from certain risks. Therefore, in order to insure that no single risk can destroy all of your investments, you must make sure that your investments are not sensitive to any single risk, and that means you must invest in a variety of asset classes, not just one. This is called diversification, and it has become the basis for prudent investment management.

An illustration of the benefits of diversification is best demonstrated using two portfolios: the first invested $25,000 into a time deposit that paid 5.25 percent per year for 25 years, while the second portfolio consisted of five separate investments of $5,000 each. The results of the second portfolio’s five segments were wildly different: The first segment went broke, the second got a return of capital but failed to earn any profit at all, and the third earned a meager 2 percent annually. The fourth segment, though, managed to produce a 7 percent annual return, and the fifth was, relatively speaking, a winner. Although it didn’t set any records, the fifth segment earned 12 percent per year, matching the average return of the stock market. The results: While the first portfolio ended the 25-year period with $96,621, the second, diversified portfolio produced $140,809-$48,188 more than the first. This result is possible due to diversification, which owes its success to the fact that the maximum loss of any investment is limited to the amount of the investment, while the maximum gain is unlimited. Thus, the profits from earning 12 percent on a small portion of the portfolio more than compensate for the complete losses incurred in another portion of the portfolio. Which sets the stage for Rule #40.

INVESTING IS NO LONGER ‘WINNER TAKE ALL’

Do you suffer from “paralysis of analysis?” Lots of people do. Fearing that they’ll be unable to pick the best mutual fund, many people wind up picking none. The personal finance press encourages this attitude, by giving the impression that you had better choose the best mutual fund or risk losing all your money. But that’s no longer the way it is.
Today, investing is not a horse race, where you make money only if you pick the right horse. Smart investors today earn a profit by picking every horse, knowing that the gains earned by the winner will more than offset the losses suffered by the loser.

Allocate your assets

Think that’s impossible? It’s not, because when you invest, the most you can lose is 100 percent of what you invested, while your potential gains are unlimited. This principle is demonstrated every year. This is why professional investment advisors don’t merely buy investments for their clients. Instead, they create complete portfolios consisting of representatives from all nine major asset classes. If you choose stocks and stocks fall in value, you might go broke. But if you invest in stocks, bonds, government securities, real estate, precious metals, natural resources, commodities, foreign currencies, and international securities, and stocks then go down, you’ll still be just fine.
But maybe you’re unswayed by this. I can understand how you might feel. You think you must pick the winner, yet you fear you don’t know how. After all, with so many choices, what’s the likelihood that you’ll pick the #1 fund? Well, here’s a new way for you to think about it. Instead of spending your life picking winners, focus on avoiding losers. It’s a lot easier, and your results will be just as good. So don’t worry about not being able to pick the fastest racehorse.  You’re now playing horseshoes, where just being close is good enough to win.

STOP TRYING TO ACHIEVE INVESTMENT SUCCESS THROUGH STOCK-PICKING

If you want to make sure you pick the winning horse, all you have to do is bet on every horse. That, essentially, is how successful money managers now make money. They no longer are worried about picking the right horse, because they know that picking every horse in the race makes winning inevitable. They also know that, in the investment world, unlike real horse races, it’s possible for every horse to win. Sure, some win more than others, but on Ajax Street, merely finishing the race usually proves profitable. That’s why professional money managers are much more focused on deciding how much to bet on each animal, rather than on trying to choose the animals on which bets should be placed. After all, how would you feel if you learned that you picked the right horse, but had placed only 1 percent of your money on him? This is why the most critical investment decision you’ll make now is choosing how to allocate your money among the many investment opportunities that are available to you. So, if you want to succeed with your investments start learning how to allocate your assets, and stop trying to pick the next hot stock.

BE AWARE OF  DIVERSIFICATION’S  EVIL TWIN

The concept of diversification is not new, although the application of it is. Harry Markowitz was the first to relate its benefits, in a paper he wrote as a graduate student in 1952. Although largely ignored for decades, the paper eventually won Markowitz the Nobel Prize for Economic Science in 1990. Markowitz’s paper (which was mostly a series of mathematical formulas) demonstrated that while a diversified portfolio’s average return will be equal to the weighted average of the returns of its components, the portfolio’s average volatility actually will be less than the average volatility of its holdings. We know this is possible from our earlier examination of various investment risks. Different investments react differently to various types of risk. For example, you know that bonds are safer than gold. You also know that inflation, by causing interest rates to rise, causes bond prices to fall. But inflation also causes gold prices to rise. Therefore, during an inflationary period a portfolio that contains both bonds and gold would decline less than a portfolio that contains only bonds. This is because inflation would cause the bond portion to decline but cause the gold portion to increase, thus reducing the overall losses. Yet the fact remains that gold itself is riskier than bonds. Thus, the two are safer when mixed together than when either one is used separately.

In other words, adding risky investments to your portfolio can reduce the overall risk of that portfolio. But this simple concept has been distorted by many financial advisors. Although Markowitz was talking about asset class diversification, many investors — and their advisors — have begun to attribute a different form of diversification to Markowitz’s theory. This new breed suggests that asset diversification  can be enhanced, and in fact, even rendered unnecessary, by time. Some advisors are of the view that the key is not when you invest in the stock market, nor which stocks you buy. The key is how long you invest. They say that you  can convert something as risky and uncertain as stocks into a safe, predictable investment. Although this statement is true in principle, you can build a portfolio that is safer and more profitable by investing in many asset classes than you can by investing in only one asset class. Time diversification is now widely used — and often incorrectly so — by individual investors and professional money managers alike. The problem with time diversification is this: Although it is true that time decreases the probability of a loss, it is also true that time increases the amount of potential losses. In other words, the longer you hold on to stocks, the less likely it is that you’ll lose money. But if you do lose money, it’s likely that you’ll lose a lot of money-far more than if you had only been invested for a short time.

Although you’ve never considered this (and it’s almost certain that your financial advisor never talked about it with you), it’s easy to understand why this is the case. Picture Lall Beharry, a 35-year-old investor who has $10,000 to save for his retirement. Most advisors would agree that you should invest in a highly diversified fashion. But Lall Beharry knows that, historically, stocks have always produced the highest returns. Since he has no plans to touch his money for 30 years, he decides to place his entire $10,000 into a stock mutual fund. Assuming that Lall Beharry’s portfolio grows at the average annual rate of 10 percent (and ignoring taxes for this discussion), his account will grow to $175,000 by the time he becomes an old man. But if, just as he enters retirement, the stock market were to suffer a 20 percent drop, he’d lose $35,000 - 3 1/2 times more than his original investment. (By contrast, if that correction had occurred shortly after he had invested, his loss would have been only $2000, or 1/17th as great a loss, of course). Because his after-correction account value is $140,000, he really has not suffered a loss. He still has far more money than he started with, and to that extent, proponents of time diversification are correct in saying that Lall Beharry, by having invested over such a long period of time, had only a very remote probability that he’d incur an actual loss. But time diversification’s critics have an equally valid point: By having invested over such a long period of time, any declines in value - if they were to occur - would be huge. This is the Dark Side of diversification. To insulate yourself from this risk, you need to make sure that you are not sacrificing asset diversification in favour of time diversification. Because with your luck, that asset will drop in value just about the time you need the money most.
(Continued next week)