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01 Nov 2009

FUNDAMENTALLY FLAWED INVESTMENT PORTFOLIOS

The worst of times can bring out the worst in people and this is no less applicable in the investment environment, where previously rosy looking investments can suddenly lose their blush.

Recently, there have been several spectacular local and international investment failures that have attracted much media attention.  Interest is often (and somewhat justifiably) focussed on the perpetrators of the collapsed schemes, their largesse and society's retribution.  However, less seems to be made of the seemingly nameless, faceless crowds of prejudiced investors.

It is perturbing to hear of people losing their life savings to some collapsed investment scheme, not only because it would be preferable if such schemes (and the people who run them) didn't exist in the first place, but more because it is indicative of a fundamental error on the part of the affected investors.

To ignore the necessity of diversification within an investment portfolio is a cardinal sin of investing.  To lose all of one's wealth to a single investment is to admit that one's portfolio was not a portfolio at all (devoid as it was of diversification).

Diversification is critically important in risk reduction.  It should be used it as often as possible, but not as much as possible.  Too much diversification reduces returns.  The more conviction you have the less diversification you need.

Diversification is critically important in risk reduction.

Firstly, what is risk, and why is diversification critically important in its reduction?  In investing, we prefer to define risk as the permanent loss of capital.  Typically, this arises when one suffers at the hands of a fraudulent scheme perpetrator, or if one indulges in the seemingly pervasive investor habit of buying high and selling low.  Once wealth is lost in this manner, it cannot be recovered.  What is more, the remaining base from which one has to earn returns is diminished, which of itself can only diminish future return expectations.

Diversification in its broader sense is critical because it prevents, or at least mitigates, such risk.  It involves investing in assets with returns that have no or negative correlation with each other.  By the same token, when choosing fund managers one should also seek those who produce returns that are largely uncorrelated with the other fund managers or with the market itself.  Diversification also reduces the risk of being wrong which is ever present in investing – to err, after all, is human; other assets should more than make up for the negative consequences of a single bad decision.  However, if those other assets are absent, then there is no compensating effect.

Use diversification as often as possible, but not as much as possible.

Secondly, diversification should be used as often as possible.  This is the antithesis of putting all of your eggs in one basket.  It is highly unlikely, unless the fiction of perfect foresight becomes ubiquitous, that any single investment will deliver precisely the return that is expected of it (some may argue that cash fits the bill, but the “cash-cannot-be-your-long-term-investment-strategy” horse was flogged to death long ago).  There is always some circumstance or discontinuity that will upset the proverbial apple cart.  Using diversification haphazardly simply leaves the investor open to the risk of capital loss if and when an investment belies expectations.

Too much diversification reduces returns.

However, the caveat to the frequency of diversification's use is the limitation of the extent thereof. Inasmuch as there is quite obviously the phenomenon of too little diversification, over diversification or “diworsification” simply regresses the investor's returns to those of the market or benchmark.

Effectively, considerable effort (and, indeed, expense) is poured into a process that yields no obvious benefit at all – a huge portfolio of investments is held and managed with little prospect of earning a return that is better than average.  Over diversification may also introduce increased trading costs as large portfolios are rebalanced from time to time, and such costs simply erode wealth unnecessarily.  Investors should seek to capture the benefits of an astute investment selection process without forfeiting all such potential gains by diversifying them all away.

The more conviction you have the less diversification you need.

Finally, the role of conviction comes to the fore.  Essentially, the more convinced you are of the certainty of an expected return, the less you need to diversify.  This is not a licence to allow an enthusiastic sales pitch to determine the constitution of your investment portfolio – the adage “if it looks too good to be true, it probably is” is a universal truth that should be heeded throughout.  But it is an investment truth that a longer investment horizon or holding period actually increases certainty and hence conviction.  Risky speculation involves a short holding period and an uncertain result; investment necessitates a long holding period and a less risky, more probable result.  Recall that diversification reduces the risk of being wrong; ergo, the more convinced you are that you are right (or the longer your holding period of a robust investment), the less your need to remove the risk of an untoward outcome.

It is this last point that is often misunderstood by investors and it is the point that is often capitalised upon by the unscrupulous investment scheme provocateur.  Investors should keep in mind that the only guarantees are death and taxes – anything else carrying that label should be regarded with circumspection.

Time may heal all wounds but it certainly proves the merit of robust and successful investment philosophies and processes.  Rather than falling prey to apparently Twainian* schemes offering riches that belie their risks, investors should put their faith in what has been tried, tested and proven.


* “Put all your eggs in one basket -- and watch that basket!” (Mark Twain, The Tragedy of Pudd'nhead Wilson)

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