Diversification is an example of a risk management tool … I take exception with it because the financial services industry promotes diversification as an ‘end’ rather than as the simple ‘means to an end’ that it really is …
Andee talks about a way to turn the concept of ‘risk v return’ on it’s head! Here’s his comment:
On the question of diversification, do you think it has something to do with risk?
I was thinking about the old phrase of Risk and Return. i.e. the higher the risk the greater the return. This has been used in the past to steer people away from high return. How about taking the opposite view which is; If you can manage the risk better than anyone else then you deserve to get the high return.
However, there’s only a limited number of risks that you can manage well and this often leads to LESS diversification and sticking to your knitting.
One of our clients said to me that he knew everything that could go wrong in his business and therefore wanted to pull money out and diversify. My question of him was this: Why would you take money out of something where you know the risk and can manage it and put the money into something different where you don’t understand the risk and therefore can’t manage it!!
If you can manage the risk better than anyone else, do you then deserve to get the high return?
Not sure about ‘deserve’, but I agree: you have to pick the return that you NEED to get then manage the risks accordingly.
If you have no particular goal in mind … other than: work until you reach retirement age, then see what you have in your 401k and live accordingly … then, you probably need to at least diversify (a low-cost Index Fund should do the trick – I wouldn’t even bother rebalancing into bonds etc.) and WAIT (at least 20 years-to-40-years) …
… but, if you do have a Number – a financial goal that is clearly set in your mind, to be achieved by a certain date – then you have to take Andee’s tack:
1. Choose your Number and Date
2. Compare that to your current Net Worth
3. Calculate your required Annual Compound Growth Rate (i.e. to take you from 2. to 1.)
4. Choose your required investment vehicle (i.e. to achieve 3. or better)
5. Mitigate the risks
Mitigating your risks means learning all there is to know about the investment vehicle/s that you chose (4.); also, choose the ‘least risky’ investment vehicle that can get you there, rather than choosing a ‘more risky’ investment that could have helped you ‘overshoot’ your Number.
What if there is no investment that you feel comfortable with that CAN get you to your Number?
a) Lower your Number by a few million, or
b) Extend your Date by a few years, or
c) Do a mixture of both …
… in other words: opt out of your dreams!
Thanks for posting my comments in the post.
if your not comfortable with investment options that fit your required compound growth rate, why not pick one, learn as much as possible about it, then invest.
maybe by learning and knowing more, your comfort level will increase.
Good point Josh.
@ Josh – That’s kind’a how I see it … we’re not born knowing anything, we try / fail / try / learn as we go / succeed.
I remember somebody telling me that when you get promoted you don’t know the job you are being promoted into or else you’d already be doing it … in other words, expect to have to learn on the job (you’ve been given the opportunity because the ‘powers that be’ believe that you have the capability to succeed, given a little time and support).
Similarly with investing: choose an investment that ‘feels’ like (a) something you want to do, and (b) has the capability to produce your required Annual Compound Growth Rate … start small and give yourself time to learn.