You may have heard the old adage: “What is worse than being lost? Not knowing you are lost.” In that same vein: What is worse than being at risk? You guessed it! Not knowing you’re at risk.
For many investors, portfolio diversification is just that. They think they are protected, only to find out later just how at risk they were.
Diversification is the holy grail of portfolio safety. Many investors think they are diversified in every which way. They believe they are as protected as is reasonably possible. You may even count yourself among that group. If, however, you answer “yes” to any of the following questions, or if you are just getting started, I urge you to read on.
- Did your portfolio take a huge hit in the 2008 downturn?
- Was your portfolio streaking to new highs until the metals prices came down a couple years ago?
- Do oil price fluctuations have a major impact on your portfolio?
- When interest rates tanked in the fall of 2008, did a major portion of your bonds and CDs get called in?
- Are you nervous before each meeting of the Federal Reserve, wondering how much your portfolio will fluctuate depending on what they say?
- Has your portfolio grown but your buying power been reduced by inflation?
- Do you still have a tax loss carry forward from a stock you sold more than three years ago?
There are certain lessons most of us learn the hard way—through trial and error. But that can be very expensive. Ask anyone who has a loss carry forward and they will tell you that the government is your business partner when you are winning. When you are losing, you are on your own.
The old saying rings true here: “When the student is ready to learn, the teacher shall appear.” Sad to say, for many investors that happens after they have taken a huge hit and are trying to figure out how to prevent another one.
Alas, there is an easier way. Anyone who has tried to build and manage a nest egg will agree it is a long and tedious learning experience. The key is to get educated without losing too much money in the meantime.
Avoid Catastrophic Losses
The goal of diversification is to avoid catastrophic losses. In the past, we’ve mentioned correlation and shared an index related to our portfolio addition. The scale ranges from +1 to -1. If two things move in lockstep, their correlation rates a +1. If the price of oil goes up, as a general rule the price of oil stocks will also rise.
If the two things move in the opposite direction (a correlation of -1), we can also predict the results. If interest rates rise, long-term bond prices will fall and generally so will the stocks of homebuilders.
At the same time, a correlation of zero means there is no determinable relationship. If the price of high-grade uranium goes up, more than likely it will not affect the market price of Coca-Cola stock. So, your goal should be to minimize the net correlation of your portfolio so no single event can negatively impact it catastrophically.
General Market Trends
An investor with mutual funds invested in Large Cap, Mid Cap, and Small Cap stocks may think he is well diversified with investments in over 1,000 different companies. Ask anyone who owned a stable of stock mutual funds when the market tumbled in 2008 and they will tell you they learned a lesson.
Mr. Market is not known to be totally rational and many have lost money due to “guilt by association.” When the overall stock or bond market starts to fall, even the best-managed businesses are not immune to some fallout. While the Federal Reserve has pumped trillions of dollars into the system, there is no guarantee the market will rebound as quickly as it has in the last five years. The market tanked during the Great Depression and it took 25 years to return to its previous high.
If you listen to champions of the Austrian business cycle theory, they will tell you the longer the artificial boom, the longer and more painful the eventual bust. Mr. Market can dish out some cruel punishment.
Diversification is indeed the holy grail, but there are some risks which diversification cannot mitigate entirely. No matter how hard you try to fortify your bunker, sooner or later we will learn of a bunker buster. There are times when minimizing the damage and avoiding the catastrophic loss is all anyone can do.
Allocating too much of your portfolio to one sector can be dangerous. This is particularly true if a single event can happen that could give you little time to react. While no one predicted the events of September 11, people who held a lot of airline stocks took some tough losses. Guilt by association also applied here. After September 11, the stocks of the best-managed airlines, hotels, and theme parks took a downturn.
When the tech bubble and real estate bubble burst, the stock prices of the best-run companies dropped along with the rest of the sector, leaving investors to hope their prices would rebound quickly.