Free Lunch: Diversification

Posted on May 25, 2010


If you are a main street investor, you’ve been sold on the idea that diversification is a great way to reduce volatility.  And in some ways it is, but it’s no free lunch by any means. Given the markets lately, I thought it a timely reminder.

From Drobny’s: The Invisible Hand

Diversification is mainly a method for reducing volatility.

…And the confusion from the fact that finance professors teach that volatility and risk mean the same thing. Diversification is not an effective method of reducing drawdowns. Moreover, diversification as a strategy can make you complacent, leading you to believe that you have mitigated certain risks that you really have not. You have to ask yourself what can you really diversify, and where.

Think of it this way, if you get 3 suites in the same hotel on 3 different floors, chances are you’ve diversified away your chance to have a loud neighbor. However, you’ve not diversified the risk associated with the hotel burning down.

Most who invest in the typical allocation of X% US equities and then Add Non-US and Emerging Markets think they’re taking away risk and volatility… they’re not. They are merely reducing their chance of having a loud neighbor. Many advisors think the best way to be conservative is to just add more bonds– the typical ballast to the asset allocation boat. As we know, even bonds have risk (especially always).

But the world is the hotel. It can burn down. Of course at that point, I suppose who cares what you’re investing in unless it’s gun & bullets, oil and water. But I digress.

It takes more to reduce risk, it takes real risk management. Diversification and asset allocation may sound nice and comforting coming from your financial advisor’s lips, but it’s simply not enough. Now, the easiest way is to manage portfolio risk and protect from big drawdowns is to simply keep higher cash balances. But that advice is something you probably won’t ever hear from your advisor, who gets paid to keep you invested in something, anything– “just keep holding on”.

Just a friendly reminder.

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