When I shared yesterday’s post about listed property on Linkedin (see here), there were many comments along the lines of “A well-balanced and well-diversified portfolio is best”. There were also many supportive comments for said comments.
But being the contrarian soul that I am – I wanted to point out that, for me, “diversified” and “well-balanced” are not the simple truisms that they appear to be.
So let me start with the general idea behind being diversified and balanced:
- Life is full of risks.
- Some risks are specific (like: “there is a risk that this company could fail because of its bad hiring decisions”) and some risks are more general (like: “global downturns make life difficult for everyone”).
- When investing your money, you want to minimise your risks.
- The total risk of any company can be broken down into specific risk (bad management decisions, etc) and general/market risk (bad global economy, etc).
- But it’s important to recognise that risks aren’t just one-directional. For example, one company can score on its hiring decisions, and do a lot better than expected; or the economy can benefit generally from a boom in investment.
- So if you split your investment amongst enough companies, then the good specific risk outcomes will offset the bad specific risk outcomes, and you’ll just be exposed to the market risk.
- Thus: risk minimised.
- Then you can do even more exciting risk diversification by saying that there are actually different market risks for different asset classes (bonds, equities, derivatives, property, commodities, etc) – so you can split your risk amongst asset classes.
- Then you can diversify out country risk by buying asset classes on multiple international exchanges.
- And pretty soon, you can diversify out everything but the general risk of a global economy.
And of course, there are many long-term studies to show that this kind of investment strategy regularly outperforms non-diversified investment strategies and it all gets a bit statistical.
I have two main observations.
Less Important Observation: Methodology and Relevance
Long-term studies in investment strategies are…problematic.
The market today is not the same market as it was 30 years ago. Or 20 years ago. Or 10 years ago. The financial wizards are constantly giving us new forms of asset class. The technology wizards are constantly giving us new ways to trade. Economic policies are in a constant state of flux. Economic fundamentals are still ineffable in all the ways that matter. Market tastes have changed. Savings cultures have shifted. The amount of money flowing around the world is larger than it has ever been.
I’m just not convinced that you can say “the empirical evidence here says…” because the empirical evidence refers to a completely different market reality.
But even if you disagree with me there…
More Important Observation: What Is Your Greatest Investment?
I’m about to sound like a self-help nut, but for most of your earning life, you are your biggest asset.
I’m not really saying that in the spiritualistic sense (although I believe that as well). Let me give you an example:
- I have a friend – let’s call him John.
- Like myself, he’s a 29 year old Chartered Accountant.
- Let’s assume that he earns a market-related salary of R550,000 a year.
- He can reasonably expect that to step up by around 15% per year in real terms until he’s 38 or so (through promotions and bonuses, etc), at which point he’s finished climbing the corporate ladder and now sits as parter/director/board member.
- Thereafter, his earnings growth will slow to, say, the 2% real growth rate, until he retires at 70.
- Up to this point, he’s managed to save R400,000 (it’s mostly locked into a bond on the 2-bedroomed apartment that he bought with his fiancée, with some of it sitting in a Retirement Annuity Fund and the residual in a small Satrix ETF investment).
Here’s his asset breakdown at age 29:
So when we say “29 year old John should diversify his portfolio”, I’d be saying: “Yes, but 99% of his assets are one risky asset”.
In fact, when you consider that risk diversification means “investing in multiple risky assets so that the risks of one offset the risks of the other”, then risk diversification for John actually means “investing in the most risky asset he can find that moves in the opposite direction to the risk that he faces as an earner”. In other words – forget a balanced portfolio for the R400,000 savings – John needs to take the big risks with his savings now.
And in terms of risk management, John needs to make damned sure that he invests in some insurance protection for his biggest asset (himself) in the forms of income protection and disability insurance.
But then consider what happens over time (and for the sake of argument, I’m going to assume that John manages to transfer 30% of his earnings into some form of savings – taking into account RAF contributions, mortgage payments, and some discretionary savings – and these manage to grow at 4% in real terms each year):
I guess what I’m saying is this: risk diversification is a sound strategy for an individual.
You have to bear in mind, in all of this, that “risk diversification” does not apply simply to your savings. It has to take into account the fact that you, as an income generator, are an asset.
And the best time for your savings to be fully diversified is when you’re no longer earning an income.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.