Stay calm, stay diversified.

Recently, Doubleline Capital’s Jeffrey Gundlach advised investors to “Sell everything” as many asset classes look frothy.

A few months ago, RBS advised clients to “Sell everything except high quality bonds. Stay short commodities, especially oil…”

While we don’t know yet whether Mr. Gundlach’s predictions (or fears, should I say) would turn out to be correct, we know what happened to the RBS prediction.

Here is a blog post analysing what happened actually post the RBS call.

In both the posts, they missed out on one thing: diversification works. Many try to predict the future, but it turns out to be a futile exercise on most occasions. This is also an exercise where repeated success is a rarity.

Stay calm, stay diversified.

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Why true diversification means saying you’re sorry

I have borrowed this title from a superb blog post by Michael Kitces that was written for financial advisors. It is such an amazing statement that many do not want to hear it from an expert advisor.

Does this mean that a concentrated portfolio would be a winning strategy? Well, the answer is “it depends”. But, depends on what? You may ask.

It depends on who you are and what you know and whether you know. To understand this statement, please read this article I wrote in May 2007.  Read a section on “Portfolio concentration” in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget“.

There is a reason why you must have a concentrated portfolio and there is a reason why you need a diversified portfolio. Understand the difference before building your investment portfolio.

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What exactly is diversification?

We have highlighted repeatedly in the book that those who do not understand, must diversify. Some time ago, we had also written an article on the subject. However, the question of diversification keeps resurfacing, why?

I think the answer is simple: A truly diversified portfolio would always have some interesting characteristics:

  1. At least one part of a truly diversified portfolio would give disappointing results
  2. The diversified portfolio would always lag behind at least some investment option
  3. A diversified portfolio cannot turn out to be the best investment option for any period you may choose. “Best” in this context means the highest yielding portfolio.

Whenever you look back at the performance of a truly diversified portfolio and compare it with anything, you are likely see underperformance against at least something – a stock, an asset category, a sector, whatever. If this causes regret, feel good, you have a well diversified portfolio.

However, is building a diversified portfolio itself an objective? Read the article we quoted earlier in this post and check the benefits of diversification and why it is the best strategy.

Diversify your investments. That is the best investment advice that you may ever get.

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Bold, confident and wrong … on forecasting and expertise

We wrote a full chapter on forecasting and expertise. It is human tendency to seek the knowledge of the future. It is good to know what can happen, but trying to find out exactly what would happen and exactly when is nothing short of day-dreaming.

Read the following article:

Bold, Confident and WRONG: Why You Should Ignore Expert Forecasts

In the context of investing, this is the biggest game being played – prediction of the market values. It is amazing how the game continues for so long in spite of the poor record of the forecasters.

It proves the popular saying wrong – “You can fool all of the people some of the time and some of the people all of the time, but you cannot fool all of the people all of the time.” Somehow the forecasters in the markets have been able to continue the game for so long. It is amazing that the tendency to know and profit from future is so strong that we ignore the track record of the forecasters.

So what do you do if you don’t know the future? Peter Bernstein’s line in the referred article says it all.

“That’s what diversification is for. It’s an explicit recognition of ignorance.” – Peter Bernstein

That’s it. Just stay diversified. It’s the best defence available for those who understand that they are ignorant.

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The risk of not diversifying

Few days ago, we explained the need for diversification: read the post here.

Now add to that three important points:

  1. The fall in the value of a concentrated portfolio as compared to a diversified one, and
  2. The investor behaviour of chasing the recent past performance
  3. At any point in time, at least one part of a diversified portfolio would outperform the diversified portfolio itself

These three statements mean a huge risk for most investors. Let us elaborate. First of all, at any point of time, the diversified portfolio would underperform at least one part of its own. In a bull market, especially, one sector would be leading the rally. This sector hogs the limelight. Since the performance is great, many investors invest in it only after seeing great past performance, which means most of the gains have been made and the prices have reached high levels. Buying costly is always a riskier proposition for investors as money-making opportunities are less of one buys costly. The faster rise is often followed by a steep fall. The leader in the rally is generally the leader in the fall, too.

since the investor missed out on the rally and entered at higher levels, there is disappointment for her.

Read more about some more examples in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget:

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The need for diversification

Why do we need to diversify?

Well, very often, people look at the performance of a diversified portfolio and compare it to one part of it. And obviously, at any point of time, the portfolio is going to underperform at least one part of itself – if it is diversified well enough. What gets discussed in public including media and what draws everyone’s attention is the winners – be it in real life or in investment markets.

However, this knowledge is available always in hindsight – after the event is over and not before. By the time someone acts on this knowledge, the gains are gone already and one ends up buying the investment at a high cost.

Many investors know that they are not the experts and hence they seek expert advice assuming that advice is equivalent to the ability to forecast. However, it is important to remember that “there are no experts, only varying degrees of expertise.” The track record of experts even in their field is very discouraging when it comes to prediction about the future. They are not even consistently wrong, just erratic.

If that is the case, what should one do?

“That’s what diversification is for. It’s an explicit recognition of ignorance.” – Peter Bernstein

Diversification is not just a recognition of ignorance, it is also a shield against one’s ignorance and stupidity.

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If you cannot predict, protect …

We have written time and again on this blog the inability of most forecasters to predict the exact events, especially the extent and the timing. However, we as humans want predictability, though we must learn to live in ambiguity and uncertainty.

Once we accept our inabilities, we start looking at the solutions differently.

In financial markets, the big lesson from the history is that most experts and common men alike have failed to predict the future, especially at the turning points. Majority of them have resorted to extrapolation of the past, which fails them exactly when the events take a turn.

In such a case, history also teaches us that in the absence of the ability to predict, one must protect what one has. Diversification is one such protection available to common investors.

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