Integrated Financial Training: Westchester NY

There are two excellent ways to suffer negative consequences. The first way is to be afraid of it. The second is to believe it can never happen...

Summary

Confidence is based upon accuracy. If we cannot predict the future, we should not be 100% confident that our suspicions will turn out to be right. Humility is more helpful. Diversification is the application of this principle of humility where you don't put all of your eggs in one basket. This can be applied to investments, but also to safekeeping your assets in numerous firms and many other areas. Knowing we have diversified can provide enough confidence to take appropriate risks.

Diversification

Fear causes one to put their money under a mattress to avoid any losses, which guarantees a loss in purchasing power due to inflation (assuming inflation is greater than zero). Blind fearlessness leads one to take absurd risks which typically cause serious losses. Diversification is a process designed to consider the reduction of risks in a realistic and healthy manner.

Modern portfolio theory refers to the principle of diversification essentially as a free lunch. The idea is that if you have two assets with the same long run return, but they tend to move in opposite directions during short term movements, you can get the same long run return with less risk if you buy both together. For example, if asset A declines 1% and asset B increases 1% in short term movements, but they both follow a long term trend of increasing 10%, then if you buy 50% of asset A and 50% of asset B, you will lock in a 10% return but with no short term variation. Assuming you have a budget allowing you to take a certain amount of such risk and the more risk you take the higher the returns, then owning both assets will increase your return relative to your risk. Then you can take more risk elsewhere and make a higher return for the same risk.

In truth, there is some benefit with diversification, but perhaps not as much as finance professors might have you think. Assets that tend to vary in opposite directions to stocks, for example, tend to go up in price reflecting everyone’s interest in lowering risk. That pushes the return in the example down from 10% for asset B, for example, to maybe 6% thereby lowering returns when you lower risk. Also, the degree to which assets co-vary with each other is not stable and predictable. In particular, right when you need the insurance (during a sudden shock), all assets have been known to drop in tandem.

However, despite the fact that the theory does not work perfectly in reality, there are some important reasons to consider diversification. No one can predict the future, and developing a realistic sense of humility is a very important tool both in financial management as well as the pursuit of happiness. A good example is the fundamental law of active investment management, which balances the number of investment decisions one makes with their ability to make better than average forecasts of their accuracy. The idea is that to outperform the market, you need to accurately assess which assets will do better than average AND you also need to make many small decisions rather than several large bets. If your investment forecasting process is good, your performance with be elevated over time. If you swing for the fences, you are likely to suffer from extreme volatility which may or may not work out so well. If the risk is higher and the return is the same, you lose the free lunch effect.

This sort of humility can be applied across all decisions. For example, having a number of asset classes can be better than one or two, given that we really don’t know how things will turn out. If we keep our money at a few banks and one of them needs to be bailed out, we may have some problems. So placing money at more banks and lowering our exposure to each is helpful. At the same time we can take advantage of the unique benefits each has to offer. If we trust all of our assets to one advisor and something goes wrong with their investment process, we may have problems there. Perhaps spreading things out a bit might be wiser.

Confidence should be based upon accuracy. If you know with 100% certainty that something will occur (rare in this world), then you can plan for it. But if you are not really sure, you should approach things with a variety of angles and look to be efficient with each approach. If you do a little better on each approach, then you can create a stable environment with perhaps some incremental improvement in returns that can build up over long periods of time. We do not swing for the fences but go for a slow and steady improvement in our situation that can accrue great benefits over time. Over-confidence is not based upon reality, leading to blind fearlessness and absurd risks which can cause serious losses. Excessive fear might lead to the mattress problem described above. Diversification can reduce the effects of Over-confidence and at the same time help those with excessive fear to take their money out from under their mattress.

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