Tag Archives: diversification

The allure of diversification …

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There is a certain appeal to diversification, particularly when seen as a risk-minimization strategy.

Rick sums this ‘certain something’ up nicely in this recommended twist to how he would set up his own Perpetual Money Machine:

Nothing in life is without risk- but you can minimize risks by diversifying- use multiple types of wealth capacitors some properties, some stocks, even some bonds. You can further diversify with a mixture of commercial and residential properties, properties in different locations, etc.

Similarly you can diversify stocks through buying small cap, large cap, mid cap, and foreign stocks.

If you diversify you can be fairly sure that one bad event doesn’t ruin everything. Of course if the sun goes supernova all bets are off but barring that you should do fine.

And, this is certainly appealing …

… don’t forget that I have been well diversified in almost every area that Rick mentions: multiple businesses; multiple RE investments in different classes (residential; commercial; single condos / houses; multifamily; retail; office; etc.); stocks (but, no mutual funds of any kind … and, I intend to keep it that way!) … but, I don’t recommend it!

Why?

I see two problems with this:

1. You spread yourself pretty thinly – you risk becoming a Jack of All Investments But Master of None … this lack of specialized expertise (which you can, of course, try and ‘buy in’) and focus can actually INCREASE your investment risk, hence DECREASE your investment returns, and

2. You automatically consign your returns to the mean/average – not all of your investments can perform as well as your best investment …. if you are comfortable with this ‘best’ investment (or, at least one of your ‘above average’ ones) surely you would put more effort into doing more of those?

The usually arguments FOR diversification then say things like “well, look at the sub-prime and what that’s done to [Investment Class A], therefore you should also do [Investment Class B]” …

… but, they conveniently forget that [Investment Class B] tanked 5 years ago, and will probably tank even worse 5 years hence, whilst [Investment Class A] recovers.

If you diversify you run the risk of averaging your returns down.

In other words, if you can choose your investments wisely your best hedge against risk are a combination of:

a. Time: make sure you can hold the damn thing for 10 to 30 years … if you have a short investment horizon, no amount of diversification will protect you.

b. Higher Returns: if you can hold long enough, every investment worth its salt will recover – and, then some; and, isn’t a ton of cashflow a great ‘insurance’ against risk?

Of course, if you can’t choose your investments wisely, then a ‘regression to the mean’ becomes a GOOD thing … just don’t expect to get rich if you can’t develop any special expertise 🙂

Nope, Rick, my Perpetual Money Machine – which asks me to generate my active income one way (e.g. my job or business), and then create passive income in another way (e.g. stocks or real-estate)  gives me all the diversification that I need!

Increase your return per unit of risk?

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Why bother?

I wrote a post about an insidiously appealing – yet flawed – approach to investing promoted by the financial services industry (I wonder if high turnover helps them or hinders them?) called ‘re-balancing’ …

… even if it were sensible (it’s not), it requires an even more flawed base to sit upon: a diversified portfolio. Now that is something that the financial services industry makes money from! 🙂

That post inspired a discussion with Jeff, who provides some useful number-crunching to support his ultimate argument for rebalancing:

Consider two cases in the first you rebalance in the second you don’t:

Rebalancing:

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
37.5K 37.5K 75K After rebalancing
75K 37.5K 112.5K Right after market recovery
56.25K 56.25K 112.5K After rebalancing

No Rebalancing:

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
50K 50K 100K Right after market recovery

Note rebalancing earned an extra $12.5K over doing nothing, it doesn’t compare to perfect market timing but there was no crystal ball required! Jeff pointed out rebalancing maintains the risk level. Was it less risky to hold half stocks half bonds? Yes, in the 50% market crash there was only 25K in losses rather than a 50K loss.

What if the order was different?

Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
62.5K 62.5K 125K Rebalance
31.25K 62.5K 93.75K Market drops 50%
46.9K 46.9K 125K Rebalance

No Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
37.5K 50K 87.5K Market drops 50%

Again rebalancing helps prevent losses over doing nothing. If you are invested in more than one asset class you should rebalance.

So, it seems that rebalancing is inexorably tied to diversification: do one and you should do the other, but what of the reverse?

Let’s turn again to Jeff [AJC: I cut/pasted a couple of Jeff’s comments … you can read the entire thread in its original form here] , who says:

If you have elected to diversify your portfolio I would argue that you should rebalance to maintain your initial asset class mix.

You add bonds to your portfolio to reduce risk. Failing to rebalance increases the your risk as time goes on…which is typically the opposite of what most investors desire. The reason you do this is not to maximize return, but to maintain the same risk that you had when you started.

The real reason people diversify into higher risk asset classes is to increase their return per unit of risk. Even when a higher risk asset class increases the overall risk of your portfolio, the excess return is disproportionately large when compared to the excess risk. Thus, overall the return per unit of risk increases, helping you to maximize the amount of return you receive for the risk that you take on.

Rather than focusing on return per unit of risk, shouldn’t we look at risk per unit of required return?

Surely we should:

1. FIRST look at what RETURN we need in order to achieve a required financial goal, and

2. THEN compare the risk-profile of the various choices that can produce the desired return or better (hence, required annual compound growth rate) NEEDED to get us there, and

3. USE THAT menu of qualifying investments to make our investment selection from?

If your financial goal – e.g. Your Number – is sufficiently large and/or your desired timeline – e.g Your Date – sufficiently soon, diversifying/rebalancing may be among the highest risk options available, along with any other investment strategy that fails to meet your required annual compound growth rate!

Diversification/Rebalancing simply may not return a high enough amount to fuel the annual compound growth rate required to get you there!

In which case, you only have some combination of the following three choices:

i) Reduce your Number, and/or

ii) Extend your Date, and/or

iii) Accept a higher level of technical risk in your investment choice/s

But, is there a point in life when it makes sense to switch to a risk-above-return strategy?

Yes!

As Jeff says:

As I get older I will be increasing the % of bonds that I hold and will be rebalancing.

But, I would not (first) look at my age … again, I would first tie this to my financial goal i.e. my Number:

When I reach my Number (or, if I fail and am within 7 years of my latest retirement age), I would shift to a Making Money 301 Wealth Preservation Strategy, such as:

1. That promoted by Prof. Zvi Bodie (Worry Free Investing) – putting 95% – 100% of my Investment Net Worth into Treasury Inflation Protected Securities (TIPS) and the remainder (0% – 5%) into call Options over the S&P 500, or

2. That promoted by Paul Grangaard (The Grangaard Strategy) – putting 70% of my Investment Net Worth into a low cost S&P 500 Stock Index Fund and 30% into a bond-laddering strategy to cover my anticipated spending for the next 5 years (then ‘repeat’ every 5 years), or

3. Putting 80% of my Investment Net Worth into positive cashflow (before tax) real-estate (I would ‘jiggle’ my deposit amount to ensure at least a 6.5% return p.a.) and keeping 20% in cash and CD’s as a buffer against vacancies, repairs and maintenance, taxes, etc.

4. If all else failed, or as a ‘last ditch’ effort to avoid leaving too much in cash/bonds, a diversified portfolio of stocks and bonds … possibly to be rebalanced each year.

But, the last word goes to Jeff:

This, of course, doesn’t mean anything unless the new return is something that you desire.

Indeed 😉

Can you diversify a business?

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I’ve just loaded 3 new videos into the Vault (click on this link, or check the VodPod Widget on the right hand side of this page for the latest) …

Now for today’s post …

Now listen up!

You want to keep working that job forever? Stop reading today’s post! If you’re determined to stay poor forever, you deserve the extra 2.5 minute break 🙂

You want to work your job AND invest in real-estate? Well, keep reading, because SOME of what I’m about to say, applies to RE, too.

But, if you want to blaze the business path … hang about, because Dustbusterz has a GREAT question for you:

Tell me here ,if I am wrong in my assessment. I believe diversifying(i.e. buying or starting many businesses) is better than having all your money tied into just 1 business.
Currently, we own about 5 small businesses, which bring in small amounts of cash. Our intent here is that we will build these businesses up gradually over a set time frame , and at the same time, continue to buy or build more businesses to add to our income stream.
By having these several businesses, we somewhat mitigate future problems if say,1 of these operations should suddenly be stricken with cancer and we are unable to restructure and save it.
So having 10 smaller businesses (1 goes bankrupt or gets sold) it is less of a drain on your income stream as having all your cash in only 1 or 2 bigger businesses.

As I said to Dustbusterz, there are some great reasons TO enter into multiple businesses and some equally great reasons NOT to …

… but, I have to admit, diversification was never on my list … until now )

First, let’s look at why you might want to buy/start just one business:

– You can concentrate on it ( THE reason not to ‘diversify’)

– One business can become many through territory expansion, franchising, joint ventures, etc.

– A bigger business can be more atractive to the people who will pay you more (say, 6 years’ profits) than the typical ‘small business purchaser’ (who might only pay 3 to 5 years’ profits); these uber-purchasers include: e.g. the private equity firms, large corporations, IPO, etc.

Now, let look at how you may end up with multiple small businesses:

– The businesses are related in some way (this is how I ended up with a portfolio of businesses)

– The first business that you buy or start doesn’t have enough potential so you open up another on the side and … it just keeps rolling from there

– You are in the business of ‘flipping businesses’ … really!

Before I continue, let’s take a break to satisfy the real-estate guys:

With real-estate you can own one property or multiple … across a single location or many. It matters not, so long as you put good management in place.

And, if you decide that you are going to be in the business of flipping RE – well, then you have no choice but to be hands on with multiple properties … you just have to hope that it all holds together!

Not so with businesses; the management requirements in small business – indeed, any business – are relatively HUGE (certainly, when compared with the management stresses in real-estate). This usually points to having one business that you grow and grow, slowly and carefully adding management layers underneath you.

I believe that by diversifying, you are exponentially INCREASING management risk (hence, failure) … which may or may not offset the potential diversification ‘benefits’.

But, it can be done … as I said before, I managed it.

And so has Brad Sugarswho is a bit of a legend where I come from … I recall going to a free ‘business seminar’ and being surprised by the speaker: a lanky kid in his 20’s in a slick business suit. And, he’s gone from there to found a well-regarded multi-national business coaching company.

Brad spoke about how he would buy small businesses, often with ‘no money down’ and fix their basic money and management problems, and then sell them off. Brad often didn’t even work in the businesses himself, so I guess that you would say that he’s to ‘random’ small businesses as Ray Kroc was to McDonalds.

I particularly loved this technique that Brad shared:

1. Buy a business for as close to zero dollars as possible (this IS possible … just offering to take on the lease payments – as a take it or leave it ‘final offer’ – is often enough),

2. Install a manager

3. Help the manager build the business up

4. Sell the business to the manager (after all, they have seen how quickly it has grown!)

5. Repeat!

Personally – like RE flipping – this is a ‘business’ (that buys/sells businesses), not an investment. It’s not the kind of business that I like, because there’s no HUGE upside; although, if you can scale upwards of 50 such transactions … 😉

The Myth of Diversification

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Important Announcement: Applications for my 7 Millionaires … In Training! ‘grand experiment’ CLOSE TONIGHT (June 2) at Midnight CST !!! This is your last chance to throw your hat in the ring …

I have been just itching to write this post … it falls straight into the category of ‘uncommon wisdom’ and will probably be jumped on by every Personal Finance author and self-appointed ‘finance guru’ out there.

All I can say is …

… bring it on, baby!

If you’ve read my posts on the only three ways to invest in stocks and the follow-up post that quoted some of Warren Buffet’s views on Index Funds vs direct stock investments, you’ll have some idea where this is heading.

But, if you’re just reading 7million7years for the first time, here it is in a nutshell:

1. Diversification is only suitable as a mid-term saving strategy – it automatically limits you to mediocre returns: The Market – Costs = All You Get … period!

Now, saving money this way, and compounding over time (a loooooonnnnnngggggg time) will put you way ahead of the typical American Spend-All-You-Earn-Then-Some Consumer ….

Just don’t confuse it with investing or wealth-building: it simply can’t, won’t, will never make you rich … nor will it make you wealthy …. nor will it even make you well-off ….

… because as long as you run, the dog of inflation is nipping at your heels!

However, it WILL stop you from being poor, broke and you may even be able to retire before 70, on the equivalent of $30k or $40k a year – not in today’s dollars, but in the inflation-ravaged dollars of the day that you retire!

But, if that’s all you need, then relax, that’s all that you need to do 🙂 But, if you need more then …

2. Concentration puts all of your eggs into one (well, a very few) baskets – it automatically gets you above average returns … if you get it right!

Investing implies taking some risk … it means choosing a vehicle (stocks, business, real-estate) … it means selecting one or a very few, well-chosen targets … it means putting your all into those well-selected targets and actively managing them for above-average market returns … until you get close to retirement.

Now, I could wax lyrical on this subject all day, every day … but, why trust me when you hardly know me and you can simply go to a source that everybody knows and can respect … Warren Buffet, who says:

I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. “Lebron James” analogy. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.

Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.

In stocks, it’s the only place where when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonalds reduces the price of hamburgers, I think it’s great. [W. E. B. 2/15/08 ]

So Warren Buffett seems to be suggesting that the average investor should be diversifying … not true. He is saying that unless you educate yourself, you should be ‘saving’ not ‘investing’ … but, here is what the difference between the two strategies means to you financially:

 i) Warren Buffet-style Portfolio Concentrationhas produced 21% returns compounded annually since warren Buffett took the reins of Berkshire-Hathaway 44 years ago. This is how he became the world’s richest man, and created many other multi-millionaires in his wake.

ii) Common Wisdom Portfolio Diversificationas measured by an index such as the Dow Jones Industrial Average (DJIA) averages out to just 5.3% compounded annually, even though the DJIA appeared to “surge” from 66 to 11,497 during the 20th century.

When you subtract 4% average inflation from each of these sets of returns, which do you think has ANY CHANCE of making you rich? 

But, it’s true that it is far better to be earning $30k – $40k (albeit in ‘future dollars’) in retirement than being flat-broke … so you need to build a safety net before you take on the additional risk that concentration implies.

Here’s how:

1. Create two buckets of money: your long-term savings, and your risk-capital.

You should first create your long-term savings bucket, as your fall-back … this means, max’ing your 401k; being consumer-debt-free; buying your own home and building up sufficient equity to satisfy the 20% Rule; and holding some money in reserve (this could be a 3 – 6 month emergency fund, or extra equity in your home that you are prepared to release in an emergency).

2. Maintain your long-term savings with the first 10% of your current gross salary, but using excess savings (i.e. any additional money no longer required to pay off debt now that you are debt-free); 50% of future pay-rises or other ‘found money’;  50% of any second income (e.g. from a part-time business) all to fund your risk-capital account.

3. Educate yourself on the investments that you will specialize in … then do your homework on the specific investments that you want to make and seek professional advice before stepping (not jumping) in.

4. If you fail … fall back to Step 2. then try and learn from your mistakes … but do try again/smarter.

Which path will you take?

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