Diversification Is Underappreciated, Part I
What are you diversifying from?
Most investors understand at least superficially the case for diversification. Not all adhere to it even at a superficial level.
The old aphorism is: concentration builds wealth while diversification preserves wealth.
I would propose a slightly amended version: concentration can build wealth while diversification can preserve wealth.
Diversification being a tool for wealth preservation necessitates the “can” (rather than an implied “will”) in the concentration portion of the old saying because concentration can destroy wealth—and often does.
But notice my insertion of “can” into the diversification portion as well. That is because diversification has its own risk/reward structure. It is definitely true that diversification is a nearly necessary technique for wealth preservation. Yet that begs the question since we haven’t defined wealth preservation yet. To fully understand it we have to grapple with the always helpful economist’s comeback, “compared to what?”.
What Does It Mean To “Preserve Wealth”
A preservation of wealth implies some kind of benchmark. Notable ones various investors use include:
The S&P 500
A 10-year Treasury bond
Some nominal cash value as of some date
A rival’s performance (friend, associate, brother-in-law, etc.)
A completely made up number (this happens way too often)
or . . . An actually good benchmark like an ability to meet one’s realistically set financial goals (spending, etc.).
The benefit diversification can bring is to prevent catastrophic loss—the very thing concentrations can entail; thus, the reason concentrations can bring tremendous gain is by virtue of (expected/required) compensation for this risk.1
If you somehow had all your wealth proportionately spread across (exposed to) the entire wealth of the globe, your only portfolio risk would be an giant asteroid or some other world-ending calamity. Since you are already running this risk with no feasible means of avoiding it, we can reasonably say this diversification would eliminate your financial risk . . . maybe.
The maybe is because we still haven’t answered the question: compared to what? If your financial goals required outperforming the average economic growth of the world, this type (not degree, that is the wrong word as I’ll explain in the next blog post) of diversification WILL fail you. You cannot outperform the world average by being exactly like the world average for the same reason you cannot outperform yourself—you cannot out run your own shadow, so to speak.
It should be obvious that before you can understand and craft how diversification can help you, you must first define your financial goals. Diversification then becomes the tool to balance risk/reward inside the framework of trying to reach those specific (and often evolving) financial goals.
The way to apply diversification as a tool is to seek a so-called optimized portfolio, which is about as problematic a concept as it sounds. And while it theoretically works in theory, it might not unless we’ve been realistic about what is theoretically possible. Even then we might fail in application.
Get Me There! However, Actually Do Get Me There
What we would ultimately be seeking through diversification is simply the safest path to the same outcome—perhaps best understood as either the path least likely to incur ruination at an equal likelihood of success or the path with the same likelihood of ruination with a greater likelihood of success. These are two sides of the same coin.
The old movie trope of jumping into a cab and telling the driver, “GET ME TO [wherever], AND STEP ON IT!” still implies some degree of risk mitigation regardless if “and I’ll cover the traffic tickets” is added on.2
Back to investing, diversification is how we attempt to reach our goals without unnecessarily tempting fate. There is no meaningful way of discussing the part of fate temptation without first defining the goals.
The “required” qualification is a technical financial term. DO NOT think of it as something that has to result because you require it. Think of it as something you require in order to get the result you seek.
In fact that always struck me as obvious nonsense because getting pulled over probably would be ruination in these scenarios. Sure, the rider might make good on this promise (sort of an insurance policy being offered to the cabbie), but if you are running a true risk of being pulled over, that might be taking on too much risk . . . on the other hand it is an indicator of the desired/needed amount of risk to be taken in order to potentially reach the goal—you can’t stop the wedding, catch the thief, or make the getaway if you drive so slowly as to avoid getting pulled over for speeding. The rider is in a go for broke situation . . . hell, that could be the whole post just in this digression.