Modern Pensées

Reconsidering theology, philosophy, culture, economics, and politics

Thoughts on Economics and Investment, Part 3: Diversification

with 2 comments

Portfolio Diversification: A Sound Strategy?

If there were a Ten Commandments of investing, “Thou shalt diversify,” would certainly make the list.  This post will explore the veracity of portfolio diversification.

Relevance of the lessons learned from ‘buy and hold’

In the previous post in this series, we challenged another member of the Decalogue, “Thou shalt buy and hold.”  We concluded that the ‘buy and hold’ strategy is highly problematic in the 21st century.  “Buy and hold” is only a self-fulfilling economic prophecy if the 21st century has the same economic growth that the 20th had, including all of its landmark innovations.  Energy and food are no longer cheap.  Science is bumping up against technological asymptotes.  Further, it should be noted that no institutional investment firm follows the ‘buy and hold’ advice.  I believe this advice is intended to bring more (predictable) money into the markets for those who manipulate the markets (institutional investors, hedge funds, big box financials…).

Why Portfolio Diversification Exists

Portfolio diversification is essentially hedging your financial bets.  In theory, hedging your bets seems like a good idea:  spreading out risk by holding positions that perform well when other positions you also hold perform poorly.   I think financial advisors give this kind of advice for three reasons:  1. Market unpredictability – financial advisors do not want to stick their head out, be wrong, and have clients upset with them  2. Risk minimization – it is much safer to have your investors have vanilla portfolios that post minimal gains/losses, plus, some people actually embrace minimal risk (esp. those retired or nearing retirement)  3. To make the market more predictable – big box financial firms want you buying their financial product, such that, their financial product can be a self-fulfilling prophecy, and they also want your money in the market to be a stabilizing influence (ie. if half the market are Joe Plumber with diversified portfolio, then it makes Big Box Financial’s or Richard Hedge Funds market manipulation simpler).

The Danger of Portfolio Diversification

Portfolio diversification can be akin to putting ice in your already cold Coca-Cola.  You trade a drop of a few degrees in liquid temperature to the watering down of the beverage.  Portfolio diversification has the same affect (and I have a deep disdain for watered down Coke).  One has to ask themselves:

If I know (or am quite confident) some particular aspect of my (diversified) portfolio is going to perform poorly this year (or insert X period of time here), why would I continue to hold the position?

Consider the following, several long held safe bets will likely perform poorly this year:

-Bonds – with interest rates so low, these will perform poorly until the global economy bounces back and interest rates rise

-Small-cap stocks – stocks that have no international aspect and are domestically focused will incur the brunt of the American financial climate without the benefit of the pockets of international growth.

-S+P 500 – some may disagree with me here, but I think the S+P is overvalued already.  David Tice at Federated Investors thinks is overvalued by 40%.

Our current administration has been pursuing hardcore inflationary policies by artificially flushing massive amounts of printed money (borrowed from the Chinese) into the economy.  These are inflationary policies, and given time they will result in inflation (it is just a matter of how much inflation).  Why would I want any exposure in my portfolio to these aforementioned investments given the financial trajectory of the U.S. and world economies.

The two dangers of portfolio diversification are:

1.  You will always have aspects of your portfolio performing poorly if you are truly diversified

2.  Diversification assumes a long-term strategy (ie. the ‘buy and hold’ strategy) that is highly problematic

Up next we will take a look at the short-term investment strategy.


2 Responses

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  1. Well Mike, I hope you’ll take this as a friendly rebuttal.

    While the 3 reasons you give for the existence of diversification are interesting (well, points 1 and 2 are mostly true, 3 seems a bit half-baked conspiracy theory) you don’t acknowledge the most straightforward, mathematically proven benefit of diversification. Which is: Given a group of risky assets with less than perfect correlation, the standard deviation (or risk) of the portfolio is always LESS than the weighted average of the standard deviation of the individual assets, while the return is always EXACTLY the weighted average of the individual returns.

    And in investments, where efficiency squeezes out just about all opportunity for arbitrage, that mathematical truth makes diversification one of the few “free lunches” out there—if you can get the same return by taking on less risk, it’s a no brainer. And diversification is the way to do that.

    Another good illustration of the benefit of diversification is here.

    The fallacy I find in your reasoning is rooted in your assumption/conviction that you “know (or am quite confident)” that some asset class within a diversified portfolio is going to perform poorly over some period of time. As an investment manager by profession and Level 2 Chartered Financial Analyst candidate, I cannot agree with that premise. The fact is that markets are ruthlessly efficient. Everything you know the market already has priced in. For example, when the financial system looked like it was about to collapse, bank stocks seemed like a foolish investment. But they were ridiculously cheap, and the brave (or lucky) who bought them when doom seemed most imminent have been richly rewarded.

    With regard to bonds, you said, “with interest rates so low, these will perform poorly until the global economy bounces back and interest rates rise.” I think you could have worded this better, but I trust you understand as interest rates rise, bond prices fall. If yields increase, buying bonds then might be smarter than buying them now, unless yields continue to increase, in which case the principle is eroded. I think bonds, particularly the higher-yielding (lower credit) or corporate bonds are a pretty smart place to have some money these days relative to the risk of owning equities, as I think inflation is still a ways off. (Yes, we’ve printed up an obscene amount of money as a nation, but the velocity of money is still very low and deflation is still a risk.)

    For every David Tice there is another analyst who thinks the S&P is undervalued by 40%. Not that I’m particularly bullish on stocks in the near term, but 40% overvalued is an extreme view that is many standard deviations away from consensus.

    DISCLOSURE: I am an registered investment advisor representative with Steadfast Financial Services and a strong believer in diversification. And I like my Coke cold, with plenty of ice. I usually drink it quickly enough to not notice any dilution.

    John Gjertsen

    January 13, 2010 at 4:51 pm

    • Excellent thoughts John. I don’t pretend to understand everything you said. Do you think you could explain your first two paragraphs in more detail, contextualized a bit.

      I think the core difference between us revolve around efficient market hypothesis. I ruthlessly deny efficient market hypothesis. I think the Austrians were correct in placing Economics in the field of Liberal Arts and not Science. If markets had no human involvement, then efficient market hypothesis would be correct. However, humans are a strange mixture of rationality and irrationality. The human element added to the markets is a game changer for me. In addition you have systematic day-traders, hedge funds, and contrarian investors that make the EMH position untenable. Irrational exuberance abounds. In an ideal market, with 100% rational investors, I am fine with EMH.

      Tice is a heavy contrarian. There could be some short run deflation, but the inflationary policies will eventually lead to inflation.

      My philosophy is a bit of a tautology, yes. It presumes that you have some surefire knowledge of the future of the market. I am not against diverstification per se. I am against holding positions that I am highly skeptical about, on the altar of diversification. Does that make sense?

      Michael Graham

      January 13, 2010 at 5:13 pm

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