Thoughts on Economics and Investment, Part 3: Diversification
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.