“May you live in interesting times.”
- Ancient Chinese curse
Many of you may not know that in addition to being a Financial Advisor, I am also a freelance professional photographer. When I photograph a wedding, I take two cameras, a wide variety of lenses, at least two of each kind of light, four light stands, and so on. Wherever possible, I have at least two of everything, and sometimes more. It makes for a large and heavy kit, so I pack everything in wheeled cases.
The reason I do this is because things break, and they are most likely to break when you are using them. To state that another way, things rarely break while sitting in my house waiting for the next wedding. They break under stress.
In short, redundancy is how I deal with surprises while photographing a wedding.
Over my many decades as a Financial Advisor, one of the top questions I am asked is how will I deal with a disaster? Some people actually imagine that as a professional I am somehow able to know when disasters are coming before they arrive and take measures to avoid the danger for my clients. I wish that was true. If I could actually see the future that clearly, I would probably be wealthier than anyone in history.
The truth is, it’s almost impossible to see disasters coming. Disasters are often the result of a surprise. And the very definition of surprise is that we didn’t see it coming.
Unlike wedding photography, we really can’t prepare for the inevitable unpleasant surprise by having two of everything. If you have shares of ABC Widgets, buying an equal amount of ABC Widgets won’t help you in the event of an unpleasant surprise. It will only make you more vulnerable to it. Buying shares of their direct competitor, DEF Widgets, only helps in the event of a company specific problem over at ABC – say an accounting scandal or some other internal issue. It doesn’t help you at all if the world stops buying widgets – if they either become obsolete, or demand drops due to recession.
Interestingly, while redundancy is no help in investments, its opposite is. With each step of further diversification, we get a little more ability to manage the risk of unforeseen events. If we own both ABC and DEC Widgets it may not help in the event of a drop in the Widget market, but we have some potential help in the case of internal problems at either company. If we also own shares of companies in other different fields, we get still more diversification and, in investments, the more diversification you can get the better.
There’s some math for this. By measuring the historical correlation between different types of investments we can see what, if any, help we might get from different forms of diversification.
Stocks in different market sectors have different correlations with each other. Bonds tend to be still less correlated with stocks. And if our goal is diversification, then less correlation is better. Less correlation means that when one thing is dropping, hopefully something else is going up, creating a smoother ride.
Here’s a few more thoughts about diversification.
- Like with almost everything, there’s such a thing as too much diversification. The downside of diversification is that the cost of managing your downside is that you probably aren’t going to grow fast either.
- The super wealthy often got that way from one company or one investment, that went wildly well. If you are very well diversified, then the impact of something going wildly well has been diminished. But that’s also the point, because the impact of something going wildly bad is also diminished.
- Rebalancing is important. Let’s say you start out with all your money equally divided between 4 different investments. Over the course of time, one or two of those investments will do better than the others. This will cause your percentages to drift. So, at the end of a year, you might have 28% in one thing and 22% in the other. You can choose to leave that unadjusted. In other words, if investment A is doing better than investment B, why rock the boat?
Because very often these two will converge again. Investment A will stagnate or even decline while investment B does better for a while. If at the end of that year you sell some of investment A to reduce it back to 25% of your portfolio and use the proceeds of that sale to buy more of investment B, most of the time that has worked to enhance your overall returns.
It can be emotionally difficult to sell what’s working so well. But when you think about it, isn’t this just a small way of buying low and selling high? Isn’t that what you want to do?
Rebalancing doesn’t always work out, but it does often enough to make it very worth considering.
So, this is the answer. I don’t try to predict surprises. I feel silly even writing that sentence. I use diversification to manage the risk that often comes from surprises.
Hal Masover is a Chartered Retirement Planning Counselor and a registered representative. His firm, Investment Insights, is at 508 N 2nd Street, Suite 203, Fairfield, IA 52556. Securities offered through, Cambridge Investment Research, Inc, a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Investment Insights, Inc & Cambridge are not affiliated. Comments and questions can be sent to hal@getyourinsight.com. These are the opinions of Hal Masover and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.