Diversification and the credit crisis

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The best personal investment and financial planning practices are durable and should not change because of market cycles and financial crises.

Less diversified active strategies tend of be sub-optimal, involving greater portfolio volatility and risk accompanied by higher costs in term of expenses, taxes, time commitment, and stomach acid. The best investment strategy is to seek complete market diversification at the lowest investment cost using passively managed and globally diversified index mutual funds and ETFs.

Nothing that has happened in the credit crisis changes the value of broad market diversification. Some uninformed post-crisis commentary has questioned the wisdom of diversification, which only indicates a failure to understand what diversification can and cannot do for you. Diversification across a portfolio can and does mitigate volatility over time.

However, when systemic factors across asset classes are in motion in the securities markets, then there is nowhere to hide, as occurred with the credit crisis. As over-leveraged investors (professional speculators “managing” other people’s money amped up with borrowing – AKA hedge funds) across a variety of asset classes scrambled for liquidity, selling pressure increased broadly and asset values crashed generally, albeit, not uniformly. Those who were very broadly diversified felt less pain, but they still felt pain.

If you really like the potential for a lot more pain, then don’t diversify. Sooner or later, that pain is much more likely to come to an ill-diversified investor’s portfolio compared to the portfolio of a broadly diversified investor. Of course, ill-diversified investors chasing tactical and active strategies are always hoping for outsized returns for the added risk.

Sadly, only a minority of active investors will get lucky, and it is largely luck (of the lack thereof) that is at play here. The percent of the lucky minority achieving excess returns tends to diminish with time — as excessive fees and taxes eat away at illusory excess returns — proving the foolishness of active strategies.

Diversification is really not an option, if your goal is optimized, risk-adjusted personal investing.

Diversification is not an optional part of family investment strategy, if that family wants to sleep well at night. When you are less than fully diversified, every day that you wait exposes you to investment risks that the securities markets tend NOT to compensate through better returns. When you are less than fully diversified, your investment portfolio risks are higher than they need to be without a reasonable expectation of getting any likely additional returns.

When you:

then you are much more likely to lose than to win. This is simply because the road you are taking is unnecessarily rough and unnecessarily winding, and you have less certainty that you will reach your goals.

You might overshoot in performance, if you are lucky. However, you are much more likely to under-perform, because of the various higher expenses and costs that continually drag down active strategies. The longer your time horizon is, then the greater the chances that you will fall behind a passive, lowest cost, market investment strategy.

A passive strategy targets a market return and can still be a bumpy ride — especially if you are not fully diversified globally and you have not adopted an asset allocation that is appropriate to your tolerance for investment risk. Nevertheless, the attendant risks are lower and potential variations are narrower than active strategies.

Furthermore, passive strategies that drive down investment costs and expenses to the bare minimum are not continually burdened by repeatedly having to pay the financial services industry a much larger and undeserved share of your returns. It is hard enough to finish a marathon without carrying water for the financial securities industry at the same time.

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Full global investment diversification using the broadest, cheapest, most passive index mutual funds and exchange traded funds (ETFs) is the most optimal strategy for the individual investor.

Few in the industry will tell you this, because a lowest cost, global and passive diversification strategy is the least profitable to the financial services industry. The securities industry looks upon you as a naive “retail investor.” The industry trains its representatives to sell to you the most profitable products that it can at “retail” prices. If you tell a commissioned financial advisor that you want to pursue such a strategy, expect to be told directly or indirectly why you are an idiot.

Through visible and hidden fees and other costs, “retail” financial services product prices are heavily marked up to compensate the industry and its very highly paid sales force. Who do you think is paying for all those tall buildings, brass fittings, mahogany tables, woolen suits, and expensive silk ties? Who pays the industry’s huge salaries and bonuses? Does the money just come out of thin air, or does it come out of your investment assets and your investment returns?

Few will tell you this fundamental truth about the superiority of cheap, passive, fully diversified broad market investing. Everyone in the industry gets paid somehow, and there is far less profit in promoting a low cost, fully diversified investment strategy. However, there is real money in it for you. In the end, you will tend to save more money, to save more time, and to save yourself from emotional consternation, when you use a very low cost, fully diversified passive investment strategy.

Complete investment diversification has become an axiom of personal investing, because the specific risks of businesses and other investment entities can be reduced or eliminated with a fully diversified portfolio without reducing your expected returns.

A fully diversified portfolio is an absolute investment necessity. Increased diversification reduces portfolio risk without a corresponding reduction in expected portfolio returns. Diversification is genuinely an investment “free lunch,” and it is a key contributor to improved investment risk management. A very high degree of diversification can be achieved through investing in a variety of low cost passively managed index mutual funds or exchange-traded funds. Such investments are also among the lowest cost investment vehicles available to individual investors in the financial markets. Given that this alternative is easily and cheaply available, the relevant question is never whether a portfolio should be fully diversified. Your investment portfolio should always be as diverse, as is economically practical.

Through investments in broad-based index mutual funds and exchange-traded funds, diversification is relatively easy and inexpensive to achieve. Attempting to become broadly diversified through the self-assembly of a portfolio of a large number of individual securities is far more difficult and much more costly. It is a simple shame that millions of investors listen to the hot stock recommendations of brokers their whole lives, when their brokers cannot know what will actually happen in the future.

Portfolio self-assembly is much more likely to result in higher risk with returns that lag the market. Buying individual stocks and bonds instead of diversified funds provides you with no advantage whatsoever. The industry likes it, because individual securities trading generates fees and keeps the charade of beating the market going. However, when you buy individual stocks and bonds, you are less than fully diversified, and you are exposed to more risk. Plus, you also get to waste your money and time for nothing. Pay more and get less. What kind of value added is that? Ignore that kind of investment counseling and financial advice.

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