Thursday, October 22, 2009

Diversification

On the subject of diversification, there had been many many articles and books written about it. I'm here to contribute more noise to it and provide another dimension on that subject.

Diversification works very well when the market is in order. We all know that the market is fairly efficient, but not entirely so all the time. To assume that each and every individual is fairly rational when they evaluate their own buy and sell transactions is, in my opinion, a much better one then the assumption that they are always rational. Thus, under usual market condition, we can expect that the market will behave in a fairly rationale manner.

When we diversify, we try to buy into different instruments in different asset classes, different sectors in the same asset class and perhaps different prices in the same counter (aka dollar cost averaging). The key point in diversification is to bet on something, yet with a hedge in case the event you are betting on did not happen. Academics had written at lengths on the optimum portfolio allocation, efficient frontier, blah blah blah. Basically, the idea is to buy non-correlated assets in a optimum mix so as to increase the returns of the portfolio without increasing its volatility.

However, there is something that needs to be thought about, and that forms the gist of this article.

In this new world where information flows fast and furious, the non-correlated asset classes - so carefully chosen in order to optimise your returns - are not so un-related anymore, especially so when the market goes into its moment of madness. What I'm trying to say is that the correlation between asset class is not a constant - it changes according to times, sometimes even direction. Take for example the usually un-questioned assumption that bonds and stocks goes in opposite direction.

The following are charts taken from yahoo! finance website. I compared the blue SP500 (^GSPC) and the red 10 yr treasury bond (^TNX) over a period of years.





You can see that there are periods of time where the bonds and stocks go in the same direction, despite the market truism that bonds and stocks are negatively correlated. So imagine, a person who blindly follows the oft repeated 'fact' that bonds are safer than stocks and that when stocks go up, bonds go down. Things are just not that simple.

But do not get me wrong - I'm not trying to say that portfolio allocation or even the idea of diversification is bullshit. It is important. However, blindly following market truism without having a thought in it can be dangerous to your financial health. Be very very careful of those one liner advice like "Buy low sell high" or "It's not about timing the market, it's about time in the market".

There are a lot of missing things not said in such truism, and don't they say "What is not said is more important than what is said"? Oops....that is also another truism for you to think about.

15 comments :

Createwealth8888 said...

Unless you are HNW or UHNW, how do you diversify effectively into different assets? What can you really do with $100K-$200K capital? Any good ideas?

la papillion said...

hi bro8888,

The standard reply is to get into a 'well diversified fund'. The non standard reply is to really monitor the few things that you know well and just do it well.

In other words, I dun have the answers haha :)

financial freedom said...

I personally feel that if you do not have a lot of funds, the amount of diversification will at the end of the day eat into your returns due to transaction costs and stuff.

Nevertheless, diversification is still very important.

Even if you watch that single basket of eggs closely, there are times when the eggs are actually FAKE eggs like some of the S-shares recently.

Basically, diversification is to minimise risk. When we minimise risk, we usually minimise our returns to a certain extent.

Thien Rong said...

I never personally look and measure the correlation of bonds, stock, gold, etc. But I saw books saying that bonds and stock are still correlated, similar to your result.

Personally, I don't like the ideas of putting your eggs in baskets you don't understand. Risks can be reduced (not avoided since there is still market risk, etc) if you understand what you are buying. Eg, how many people who bought the Lehman Brothers understand it at all?

If diversification involves buying a dozen of funds, indexes that invest your money in another dozen/hundreds of companies, you end up having so many companies you don't even understand and much less how it will impact you.

Neverthessless, diversification is important as finanical freedom mentioned about the example of fake S-share. Probably, hard to avoid unless SGX get stricter or you don't invest at all in company you don't trust.

Anonymous said...

Hi LP!

Diversification is more for "novice" like me.

Those who are really good in what they are doing and are comfortable in what they do, seldom diversify.

HH

la papillion said...

Hi FF,

Actually i agree with you. When you funds are limited, you just have to be more selectively in what you are buying and watch more carefully.

Some pple I know actually buy pennies, because of their low capital (and able to get more shares for the same $). Not a good way to start this game at all.

la papillion said...

Hi Thien Rong,

I think the modern portfolio theory (MPT)is for academics only. I'm not too sure about it, but some of the underlying assumptions are questionable already. A key pt is that they treat volatility as risk - something that I don't understand.

Either way, I do not really subscribe to the MPT. I get the key idea and the importance of diversification - but that's about it. The 'how' part, I guess I have to figure it out myself. Very simple rules like not owning more than XX% of your holdings in a particular sector, or rebalancing periodically is good enough. I leave the 'efficient frontier' and 'optimisation' to the academics who touted it.

la papillion said...

Hi HH,

Haha, you're novice? Then I ikan bilis already :P

Probably is, we always think we're better than average. Then who's the average?

PanzerGrenadier said...

Hi LP

The more I manage my own money, make mistakes and make right moves, I learn that diversification means different things to different people.

For majority employees/self-employed, our main career/business is actually the main asset class, i.e. ourselves Pte. Ltd. generates the most earned income when saved becomes our investible capital.

One of the easiest form of diversification for me is to have a chunk of 5% to 80% at any stage in cash/cash equivalents (fixed deposits/treasury bills/foreign currency fixed deposit - very speculative!)

Thus, don't jeep all your capital. That is the most straightforward form of diversification that works for me.

Be well and prosper.

BTW, thanks for the ebook on trading, starting to enjoy the writing style!

Anonymous said...

Hi LP!

"Novice" is someone who never move on to the next level.

gurus' view on investment
________________________
Jim Rogers: “I haven’t met a rich technician.”

Marty Schwartz: “I used fundamentals for 9 years and then got rich as a technician.”

John Templeton: “Diversify your investments.”

Warren Buffet: “Concentrate your investments.”

(Quoting super-investor Warren Buffett: "I cannot understand why an investor elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices ...")


Bernard Baruch: “Don’t try to buy at the bottom or sell at the top.”

Paul Tudor Jones: “Everyone says you get killed trying to pick tops and bottoms and you make all the money by catching the trends in the middle. Well, for twelve years I have often been missing the meat in the middle, but I have caught a lot of bottoms and tops.”

**One thing in Common:***

Jim Rogers: “My basic advice is don’t lose money.”

Marty Schwartz: “The most important thing in making money is not letting your losses get out of hand.”

Paul Tudor Jones: “Don’t focus on making money; focus on protecting what you have.”

Warren Buffer: “Two rules of investing: (1) Never lose money. (2) Never forget rule #1.”

Happy investing!

HH

la papillion said...

PG,

Haha, glad you liked the books :)

I do agree with you that diversification means different things to different people. For some, merely putting into different stocks is a form of diversification already.

Good luck trading :)

la papillion said...

HH,

Wonderful quotes!

Gng to do a blog post on it. I feel the same sentiment when I read so many pple and their different views. Read until blur, haha

SGDividends said...

Hi LP,

How about this quote by warren buffet........

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it

la papillion said...

Hey sgdiv,

Haha, nice one, read it before. However, there's a lot of pple trying to be W.E.B but they are not, just like there's a lot of average investors thinking they are not the average.

The result? just plain confusion, thinking that holding long term with ANY stocks on a concentrated portfolio is good.

Sgbluechip said...

Hi LP, investing in companies with diversified businesses are also a form of diversification. Good example of such companies are keppel corp and Semb Corp.

The extend of diversification really depends on the risk threshold of a person. Personally, I rarely diversify to more than 8 stock counters, as I manage my funds rather actively and recycle cash returns among the 8.

Also, diversification does not mean that risks are reduced. If you look at random funds, their volatility for the past 3 years is much higher than a low beta stock like Singpost and SPH.

Sometimes we are constrained by the circumstances to diversify as well.

Example, I can't diversify my marriage risk by having more wives... hahaha!