I wrote a piece for The Fleet Street Letter (FSL) this week. In it, I described a dangerous disease that often infects investors, making them total slaves to diversification. And it’s such a useful insight, that I thought I should let you know about it too.
In case you don’t know, FSL is a newsletter – the aim is to bring readers the benefits of a managed portfolio, but (and crucially!) without the inordinate costs levied by the financial industry.
Anyway, the point is, the FSL portfolio is what, in City parlance is deemed ‘concentrated.’ Basically, the portfolio homes in on six key sectors (including energy: you may have noticed we’ve been banging the drum for natural gas recently). Now, when it comes to equities, there are about 40 sectors in the market – things like mining, financial services, aerospace, etc. So the fact that we’ve selected only six as the backbone to the portfolio really says something.
Now, before I go on, let me just say that, yes – I am a big fan of diversification. And the portfolio does include a wider base of sectors than the six at the core. But diversification is often misunderstood – it often becomes the tail that wags the dog. Many investors think that diversification limits risk by piling in lots of different stocks from lots of different industries. You know, the ‘don’t put all your eggs in one basket’ type of thinking.
But this is only half the story. The real value of diversification comes when you see how your portfolio reacts to different scenarios. And here I’m talking about macro scenarios. Things like inflation, or financial shock; or even the good stuff like economic growth and bull markets.
You don’t need me to tell you that in the event of a market crash, it doesn’t make much difference how well diversified your stocks are… they’re all going down!
Safety must be your number one priority
As I’ve already alluded to, safety is key. Before you even consider what returns your investment may make, you have to consider safety – will you get your money back?
The markets offer a full range of investments across the risk spectrum. And the key is, you must weigh up risk and reward. I am all for holding some risky stocks… but only if I’m confident the rewards will be huge if I get it right.
But many investors hold assets that produce a reasonable reward, but fail to take account of the risks – some even hold assets with a poor reward, even though risk is considerably higher than they realise! A great example of that is of course US Treasuries. Not so long ago these things were yielding 1.6%. Just consider that.
US inflation is running at about the same rate; that means investors can’t ever hope to achieve what we call a ‘real’ return. But moreover, this is in a country that may soon default on its bond payments. Now, as it happens, I suspect that any such default will be a very short-term thing. The central planners will find a way of printing money to pay down debt. But the point is, that’ll only ever lead to inflation. No matter what anyone says, history has been a fantastic guide on this point.
Everything that the academics have taught us over the last thirty years on the subject of financial risk has been turned on its head. Put simply, the risk free asset is no longer risk free. Yet people still pump money into government bonds as if they are the only safe thing in town!
But if you consider the effect that inflation could have (and did have during the 70s) on this asset class, you’ll see that this is far from risk free.
Who are you investing in?
Safety is best assessed using what the pros term a ‘bottom up approach’. Yet most investors assess it ‘top down’. That is, they try to use asset classes to diversify away risk. But if you really think about it, you know in your heart that what really matters is the risk profile of the individual stocks in your portfolio. And the way to build that into your portfolio is by what we call the ‘bottom up’ approach to investing.
Warren Buffett was once asked where he got his investment ideas. He duly explained how he reads company reports and accounts and learns all about the individual businesses. But the reporter replied: “But there are 27,000 public companies!”
The response was classic Buffett: “Start with the As”.
I cannot emphasise enough how risk all boils down to knowing who, exactly you have invested your money in. I have lost money on ill-fated investments many times over the last 30-odd years. And it’s always because I’ve misunderstood the risk involved with the entities in which I’ve invested. The really irksome thing is that had I done a little more research on the individuals (not the business) involved, I probably would not have invested.
The problem as I see it, is everyone seems to focus on the reward from the investment. They then use diversification to try to limit risk. But this is muddled thinking. And it brings me to an old market truism: “Nobody ever got rich following a great diversification strategy.”
And I’d just like to add to that, that you can’t expect to stay rich through diversification alone.
The key lesson is: do your homework. And if you don’t have the time, then why not join us at FSL where we’ll do it for you?
• The Fleet Street Letter is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Please seek independent financial advice if necessary. Fleet Street Publications Ltd. 0207 633 3600.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
Information in The Right Side is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Right Side is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do
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