The Failings of Traditional Diversification
“Make the Mistakes of Yesterday Your Lessons for Today.”Before we begin to carefully craft our diversification strategy, it’s best to learn from other’s mistakes, or perhaps even some of your own. The last thing we want to do is repeat mistakes when they are unnecessary by walking into the same quicksand pit of other “diversified” investors.
Traditional diversification advocates spreading your equity (your total money) among various geographies or sectors. For example, you’ll often read that the safest portfolio is one that has money invested in companies that are spread around the world. So choose companies, they advocate, with the majority of their business in different regions of the world. This is often referred to as geographical diversification. While at first glance this seems to make sense… to invest in different part so the world separated by vast oceans and space, take another look. There is a significant problem with this traditional view of geographical diversification and it is this: It’s a Small World After All (take a read of this article). You see, with the “global economy” so intricately intertwined, the ripple effects of what happens in one part of the world are felt in other parts of the world… and sometimes, those ripples feel more like Tsunamis. While the epicentre of a crisis may be off the shores where you invest, the effects eventually reach your portfolio and, in some very tragic cases, may erode much of your portfolio.
Another approach to diversification that is just as common as geographical diversification is sector diversification. At the core, this is simply choosing assets that operate in different sector (or segments) of the overall economy. You know… like the energy sector, the metals and mining sector, the healthcare sector, the real estate sector, etc. To find a basic list of the various major sectors, you can go to Yahoo (I’ve linked to an extensive list for you) or other similar financial sites. So, if you have IBM and BIDU, they are both technology related and, therefore, may not be as diverse as KO (Coca-Cola) and IBM. Once again, the effects of one industry seem to impact the others as fuel costs raise the expenses for most companies and commodity prices impact every sector which relies on raw materials.
Perhaps the greatest problem with the traditional approach to diversification does not take into account a basic reality! In fact, especially if you are a new investor, you need to always remember this basic fact: 80% of stocks move in the direction of the market’s overall trend. So, even in a traditionally diversified portfolio, 4 out of every 5 stocks are likely to move with the markets. That’s why in 2007-2008, so many “diversified” investors got burned. You see, it didn’t matter what part of the world their company had its primary business or in what sector they operated. Everyone and everything was impacted by the credit lending crunch… because they all need money to continue to grow, whether it be from an institutional investor, a financial institution, or a consumer buying their products. Even those in gold saw the index drop approximately 30%, an unusual movement when traditionally many investors flocked to gold when stocks would plummet.
Ready to Diversify?
It’s really important that we don’t rush ahead… and leave anyone behind. So, I’m going to pause here and ask you to provide me with some feedback. Are these traditional forms of diversification familiar to you? Have you used them before and wondered why your portfolio is still being eroded by the ebb and flow of the overall market conditions? I’d love to hear from you… so again, please take a moment to leave a comment, ask a question, or simply hit the google+ button if you enjoyed this article. And check out this E-Book: Diversification Strategies.
Then, join me again in a couple of days for some practical steps, that will benefit both brand new investors and seasoned investors, toward how to diversify your stock portfolio.