Here’s an observation: people are bad at risk management. Oh, we think that we’re quite good at it. We say things like “A well-balanced and well-diversified portfolio is best”. But we’re often not that clear about what our true portfolio actually is.

So being the contrarian soul that I am – I want to point out that “diversified” and “well-balanced” strategies are not that simple.

Managing Your Risks: The Background

Here’s the general idea behind being diversified and balanced:

1. Life is full of risks.
2. 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”).
3. And when investing your money, you want to minimise your risks.
4. 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).
5. 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. That is, some companies will make good hiring decisions and do well, while others will make bad hiring decisions and do badly – but that should all balance itself out, and you’ll end up only being exposed to how well the economy is doing.
6. Thus: risk minimised.
7. 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.
8. Then you can diversify out country risk by buying asset classes on multiple international exchanges.
9. And pretty soon, you can diversify out everything but the general risk of a global economy.

And there are 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:

1. I have a friend – let’s call him John.
2. Let’s say that he’s a 29 year old Chartered Accountant.
3. Let’s assume that he earns a market-related salary of R550,000 a year.
4. 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.
5. Thereafter, his earnings growth will slow to, say, the 2% real growth rate, until he retires at 70.
6. 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 balance in a small Satrix ETF investment).

Here is his asset breakdown at age 29:

So when we say “29 year old John should diversify his portfolio”, I’d be responding with: “Yes, but 99% of his assets are one single risky asset: himself”.

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.

What happens as that ‘big risky asset’ gets realised as income?

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):

Over time, John’s asset base changes, as he converts his ‘big asset’ into other assets. And as that happens, his risk diversification strategy has to to change as well.

The Conclusion

I guess what I’m saying is this: risk diversification is a sound strategy for an individual.

However.

You must bear in mind that “risk diversification” does not apply only to your savings. It has to take into account the fact that you, as an income generator, are an asset.

When that asset is large, you should be taking more risks with your ‘savings’, and making sure that you’re ultra-conservative with the insurance policies. And as that asset diminishes, you should take less risks with your ‘savings’, and you can start easing off the insurance.

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.