November 21, 2010

Why We Diversify

Financial planners understand that protecting against the downside is the first step in investing.

Europe’s debt crisis has hung like a dark cloud over a market that was supposed to soar on QE2 and options expirations. Indeed, even the best laid schemes of mice and Fed chairmen go oft awry.

The pressure on Ireland to accept a bailout brought unwanted attention on Greece, which is heading towards default as soon as January. The EU hopes an aid package for Dublin will stabilize the euro bond markets and take pressure off of Spain and Portugal.

But no deal is going to keep bond investors from noticing their excess of debt. In fact, it’s only the relative severity of Europe’s problems that have averted greater vigilance about ours — for now. (Mark this well, Harrisburg, Penn., California and Secretary Geithner.)

This crisis demands a return to first principles. Financial Planning 101 teaches that people (and nations alike!) should above all avoid insolvency and instability in their finances. People (males particularly,according to behavioral finance research) seem to be poorly wired for investing.

They tend to have an inherent optimism and often overconfidence in their portfolio decisions. They invest not only money but also hope as they anticipate success.

But this is the wrong approach. Just as doctors are instructed, “first, do no harm,” so too financial planners understand that protecting against the downside is the first step in investing. You might think that Acme Widgets will shoot to the moon; you might think that it’s a steal at its current price-to-sales ratio; but you might be wrong.

After all, every stock you buy is obtained from a seller who is happy to part with it at the price you’re paying. Maybe the seller knows more than you. That’s why the most important investment stratagem is diversification. While it’s true that diversification lowers the volatility of your portfolio and enhances returns, its dramatic reduction of risk is its most important benefit.

In a new book written for novice investors, That Thing Rich People Do, Kaye Thomas makes the point probabilistically.

If you’ve chosen 10 stocks as candidates for your portfolio and buy just one of them, there is a 1 in 10 chance you chose the one that will perform worst. If you choose 2 of the 10, there is only a 1 in 45 chance you chose the two worst.

Divide your money among all 10 and you’ve minimized the risk in your portfolio. In fact, the portfolio risk is lower than that of the average stock in the portfolio because of the smoothing effect of the stock prices moving up and down at different times.

Financial planning comes to teach that we can and should reduce risk and aspire to steady returns. While we cannot predict the future — indeed, because we cannot predict the future — we should plan our finances in such a way as to avoid calamitous outcomes.

Failure to do so undermines our self-sufficiency and risks making us dependent on others at some future stage of life. And this at a time when many nations, our own included, are accumulating excessive debt, living for today at the expense of our future.

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