What is diversification worth?

In the investing world, diversification has the feel of holy writ. No one conventional will ever question it.

The reality, however, is that diversification is frequently taken out of context and misunderstood.

For example, many investors are sold on the idea that diversification will prevent their portfolios from tanking when markets go haywire. But, this is seldom the case. Perhaps one's portfolio goes down 40% instead of 50%, but that's the best-case scenario at the absolute worst part of a market downturn. How many people are really happy about being momentarily down a little less than the overall market?

I've seen presentations that show much less "reduced volatility"--down 10% instead of 11%--pitched as the holy grail, but I've never heard a client say, "Boy, am I glad I was diversified," with such small differentiation.

As with all things in life, there is a cost to diversification: usually lower returns. The sales pitch is that you give up some return in exchange for lower volatility. That's great, but it must be thoroughly understood that giving up return means less money in retirement. I think many investors would prefer higher volatility and a better retirement, and they should make that choice with a clear idea of what they are choosing. I would happily take 10% more volatility and 10% more income in retirement, and my guess is that I'm not alone.

Diversification is a benefit, but that benefit has limits. A portfolio of 100 stocks should probably be replaced with a low cost index fund. A portfolio that is 80% in your employer's stock is not very smart. Somewhere in between those two extremes is diversification that works for most people.

Diversification works because it removes the consequences of not being omniscient. No one, not even Warren Buffett, knows the future with precision, so that type of diversification is prudent. 

That does not mean buy a little of everything and the more the merrier. Over-diversification has huge penalties, too, and that comes in the form of lousy returns.

The benefits and drawbacks of diversification seem clearer after the market has tanked and rebounded like it has over the last week and a half. There was little benefit to being investing in one stock versus another, because they almost all went down and back up together. 

The things that did do well, perhaps gold and U.S. Treasuries, either have been or will be terrible investments over 5 to 10 year periods. To gain their benefit in somewhat reduced volatility is to lose future returns that may be worth much more. Perhaps that's not what everyone wants or needs.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The stock market wakes up to global risk

Surprisingly--to me, at least--the market has finally woken up to global economic risks.

The signs were there before: commodity prices tanking, emerging markets in heavy decline, state interventions in Greece and China, accusations of broad corruption in places like Brazil.

The question investors will be asking themselves over the weekend is: is this the beginning of a bear market or just a brief pullback to be bought into?

I'll spoil the suspense: no one knows. Only in hindsight is it clear when bear markets begin versus temporary pullbacks.

What I do know is that a significant pullback or a bigger bear market are both opportunities for investors. During such times, psychology takes over as some people panic, and that means something is being sold too cheaply.

To benefit from such situations, the goal is not to pick the absolute bottom in the stock market or a particular stock, but to know what specific securities are worth--after arduous research--and then to buy accordingly.

When people ask me if such pullbacks scare me, I always say "No!"  Such times are great opportunities to benefit from the panic of others.

In other words, I'm excited to go shopping.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

China's transition

Outstanding article on China from Stratfor.  The image that many have of China's economic growth and political freedom are at odds with the facts.  This article does a great job of showing where things have been, where they are now, and where they may be going.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

China is looking increasingly desperate

Paper was first invented in China. So was paper money, and thus runaway inflation. It is interesting to see China return to its historical roots this week with the significant devaluation of its currency, the renminbi.  

China's actions make it look desperate. The Chinese economy is slowing down, perhaps more rapidly than the communist party in China would like. They have tried spurring stock market growth, and then propping up the stock market to prevent it from falling. Now, they are devaluing the currency to try to get the economy jump-started.

Real economic growth comes from productivity, not from printing currency, redistributing wealth, spurring stock market speculation, or punishing those profiting from stocks falling. All of China's, or Europe's, or America's, or Japan's attempts to get growth from someplace other than productivity (which isn't in the government's wheelhouse) are doomed to failure.

Devaluing the renminbi is an attempt to make Chinese goods cheaper for foreigners to buy. That "works" as long as no other country decides to devalue their currency, too. And, it assumes that market participants are too stupid to adjust prices based on currency manipulation, which history and academic research has been shown not to be the case.

It should come as little surprise that communist dictators misunderstand how a free market works. China is running the risk of not only disrupting the world economy with its actions, but also definitely proving to Chinese people that they don't know what they are doing. The risks and the results are real, and will be felt worldwide.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.