What you are about to read may enlighten you. Or, if
you are a savvy investor, what follows may re-enforce what you already know.
However, if you strongly believe that diversifying is a way to reduce risk and
practice the often-repeated phrase, “don’t put all your eggs into one basket”,
then – not to be rude but – you may not
want to continue beyond this sentence.
Well, you are still here. That is good, especially if
you are under the influence of the “diversify to reduce risk” way of thinking.
It’s sacrosanct to many in the investment industry and my statements below are iconoclastic.
They go against the widely held belief that diversifying reduces risk and will,
frankly, piss off many people.
However, knowing that you are continuing to read this shows
that you want to discover a different perspective on diversification. It shows
you care about your money, your future, and your loved ones futures.
You will learn why many financial advisers choose
diversification as their main investment strategy along with two very important
reasons why diversifying can increase investment risk.
Learning why diversification is not the ideal risk
reduction method may prevent you from having below average returns, or in some
instances, it may even protect you from massive financial losses. And I don’t want that to happen to you!
So, please read on…
1. First Reason as
to Why Diversification Can ‘INCREASE’
Investment Risk…
So, what is the first way that diversification can
increase investment risk? In short the answer is: diversification is spreading
money around with the hope that, in the end, money will be made.
Diversification, more than likely, is due to a lack of knowledge and confidence
in what to invest in properly. Without proper due diligence into what is bought
in the diversification purchase and an awareness of impactful industry and
economic developments, diversifying is the equivalent to throwing wild,
unfocused and untimed punches in a fist-fight as opposed to covering up,
bobbing, weaving, and feinting to test your opponent’s skills and wait for an
opening where you will then direct a 100% calculated strike at the jaw line,
scoring a knock-out. The former will drain your energy (and if you’re in poor
shape, bankrupt it), and open you up to being hit or outright pummeled.
Conversely, the latter puts you in a position to see an opportunity after
closely observing your adversary. By studying what you’re going up against
mindfully, you gain an understanding of how your opponent operates (Mr. Market) and can therefore capitalize on weaknesses and opportunities.
Leaving this metaphor and jumping into the investment
arena, analyzing investment choices closely, understanding how they move, and
knowing what the influential factors are before investing in them gives you a
much better chance of either avoiding a financial loss or scoring a massive
gain, (i.e. a knockout, with just one investment.)
Diversifying without a lot of attention to influential
details is a dangerous way to use investment money. You cannot diversify away risk because risk can’t be
eliminated. Risk can only be exchanged, transferred or hedged.
Unfortunately, you may not have the time to devote to
not only researching investment opportunities but also developing the
analytical and business knowledge necessary to make prudent investment choices.
If this is you, don’t feel bad. Surprisingly, many financial advisers (FA’s)
suffer from lack of time as well.
Many FA’s are charged with bringing in new clients to
help their investment firms gain wallet share. This is their main responsibility
rather than making certain the money under their watch is in the most secure
and best-positioned investments. This is not due to an inability to discern the
best investment decision but rather due to simply not having enough time to
gain the proper "know-how". They are under pressure to bring in new clients and
retain the old ones. Choosing the best investments for his or her clients is
not the priority. To save time, they
diversify. However, as one investor stated, “Diversification is protection against ignorance. It makes
little sense if you know what you are doing”.
That investor is Warren Buffett.
This lack of understanding can reduce the FA’s
confidence to justify purchasing a specific security in a targeted asset class,
such as in software technology. In this scenario, the FA relies on third party
investment products and/or picks a diversified mutual fund or ETF to do the
actual investing work. They distribute the investment money into a number of
highly diversified vehicles to spread-out the risk. It also clearly illustrates
that the FA lacks his or her own investment ideas.
If you have entrusted a financial adviser to invest
your money, I urge you to learn how this person invests. If the FA is like the
masses of others in the financial services world, third party diversification
products is the number one way to invest.
This should
concern you - Why? Because you gave
your hard earned money to a financial adviser who’s main responsibility is to
get your money into the coffers of his or her firm – not to make certain that your
money is going into the best possible investment opportunity. The financial adviser
is under pressure to produce. He or she usually has to meet sales targets to get
as much money from people as fast as possible into his or her investment firm. Once
the money is had, it is then put into investment products that are created
and even managed by third parties – people that don’t work for the financial
adviser’s firm.
So, you gave your money to your FA who then basically put
it into an investment that was created by someone completely unrelated to the
FA’s firm. Your FA basically outsourced your money!
Ideally, you want your FA to work at a firm that has
its own investment ideas and investment products. You want your FA and the
people in its firm to be diligently analyzing stock fundamentals, determining
their intrinsic value, looking at technical indicators, and deciding if it is
time to buy or sell.
You want your FA’s main responsibility and mindset to
be to put your money in the best investment opportunities, rather than to get
as many clients and money into the firm. To illustrate, this financial adviser
follows say, a NASDAQ tech stock and is able to recognize its intraday, daily,
weekly, and quarterly trading pattern as well as understand how its price is
affected by micro and macro economic and industry specific events. This close
analysis gives a much better probability to enter into an investment at the
right time and know when it’s the right time to exit. Again, you want the focus
of your financial adviser to be on getting the best return for the client –
i.e. YOU – rather than on getting more clients. Does this sound selfish? Well,
if your money is at risk, I encourage
you to be very selfish and protective.
Also, you want your financial adviser to eat what they
cook. That is to say, your financial adviser should be placing his or her money
in the same investments that your capital is allocated to. It’s a very good
test to learn if the financial adviser trusts his or her own investment advice.
If the FA does not have his or her funds in the investments that you bought into,
I have to ask: why would you invest in something that your adviser
isn’t completely confident about?
This year, volatility in both the stock market and
bond market is expected to continue. The damaging effects of the risk on/risk
off trading environment sparked by the Fed's tapering will continue to leave
investors on edge. So its important to
have an exit plan and be nimble in executing it.
The time-crunched FA will likely go with placing
capital in a broad, lumbering, less understood diversified portfolio. It’s
really the difference between a thoroughly researched and well-timed investment
strategy and a spread out investment wager especially when the overall 2014
securities’ market environment is not brought into the investment decision
process. This leads me to my next point.
2. The Second
Reason as to Why Diversification Can INCREASE
Investment Risk.
The second reason why diversifying can increase
investment risk, especially when handled by that time-crunched financial
adviser mentioned above, is thinking that diversification will protect against
a massive loss if the overall economy and/or stock market tanks. This may minimize a loss. However, there will
still be a loss. Its extent will depend on just how “well” diversified the
investments are, of course, but that really equates to shuffling the chairs
around on the deck of the Titanic. Everything
will go down!
The “multiple egg basket” way of thinking pushes the
belief that if you drop one basket, you won’t go hungry. However, there is
deception with this because investment risk cannot be eliminated 100%. It can
only be exchanged, transferred or hedged. With diversification, you are not limiting risk.
You are exchanging it.
However, if one is closely in tune with the national
and international economies and stock markets, along with what drives the
behavior of specific securities, then these major downside market moves will
most likely be seen in advance. From this vantage point, it’s easy to not only
take defensive action, (i.e. exit susceptible investments, but also engage in
offensive action via shorting the market, and/or stock(s), or hedging against
potential drawdowns). However, the latter approach takes a lot of time and
effort to pay attention to the global variables that influence placed-money
that expects a return. And, in today’s investment environment, particularly the
electronically traded one, being well informed and agile can certainly mean the
difference between losing money and making money.
So, what I want you to learn from this brief
investment note is: diversification is not the best risk reduction method
available. And if diversification is done in place of careful analysis, then increased
investment risk is the most likely outcome.
No forecasts can be guaranteed.
The views expressed are those of
Fifth Capital Management and are subject to change at any time. These views are
for informational purposes only and should not be relied upon as a
recommendation or solicitation or as investment advice from the Advisor.
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