Has anybody told you not to put all your eggs in one basket? Have you ever seen anyone with chickens collect eggs? It’s always just one basket. As the
old saying goes, “As with chickens, so with investing.” Okay, that’s not a real saying. But the point is: why and how do we diversify investment portfolios?
If you want to make money in the stock market - like, turn $1,000 into $100,000 money - you won’t do that with diversification. Well, you will, but it’ll take
50 years. The quickest way to make money is by making a very small number of very concentrated bets... and then hopefully the bets pay off. Think of any
famous investor, and they’ve probably made their money that way.
The problem is, it’s a huge gamble. For every one investor you just named, there are hundreds that nobody has ever heard of, because they went bankrupt.
That level of risk is unacceptable for the vast majority of people. Unlike chickens and eggs, you don’t wake up to a brand-new, fully-funded 401(k) every
morning. If you know you’re going to need to use your investments down the road for retirement, the possibility of losing all your money should never be on
the table to begin with.
Yes, turning $1,000 into $100,000 a couple times over would be nice, but we’ll choose instead to take the worst possible outcomes off the table and make
money the old-fashioned way: Savings and Time. And so we turn to diversification. Diversifying will not make you money, but it will certainly minimize potential
losses.
What exactly are we diversifying? The portfolio, yes, but more specifically, we are diversifying the risks to the portfolio. Consider a portfolio of 100% Apple
stock. Clearly, not very diversified. Returns have been excellent, but suppose the new iPhone 11 goes all Galaxy 7 spontaneous combustion. Goodbye returns.
Now consider a portfolio of 5 stocks: 20% each of Apple, Google, Samsung, Facebook, and Amazon. That’s more diversified, because you are less exposed
to those Apple-specific risks. You even have some international exposure from Samsung!
But consider a different portfolio of 5 stocks: 20% each of Apple, Home Depot, AT&T, Exxon Mobil, and JP Morgan. Those are all US companies, but might
you consider that portfolio to be more diversified than the all-tech portfolio?
You can actually calculate an answer to that question using the correlations between the various securities. We won’t bore you with the details, but yes,
that second portfolio is objectively more diversified than the all-tech portfolio. And even more diversified would be a portfolio of Apple, Home Depot, AT&T, JP
Morgan, and Treasury bonds. See where we’re going with this? The more part of your portfolio zigs while the other part zags, the lower the overall portfolio
risk and hence the “better” the diversification.
The tricky thing about diversification is that it changes depending on what risk prism you’re looking through. Portfolio construction then becomes part
science and part art - art, to imagine the various risks facing a portfolio and then construct it in such a way as to minimize the impact of any individual risk
while simultaneously maximizing potential return... and then constantly reassess.
Diversification is a necessary component of investing when you’re dealing with money you can’t afford to lose. But ultimately, it’s a tool. And like any tool,
sometimes it’s more useful than other times. The trick is in figuring out the when, the why, and then the real kicker is the how. If you need some help with
that, well, that’s what we’re here for.
TYBEE BEACHCOMBER | NOV 2019 7
Rogue Waves By Russell Robertson, CFP