Macro Economics
Fireside Chat on Diversification

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By washcomp
July 27, 2009

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OK, in reality, I have no fire, and this isn't really a chat I think some might find it disturbing, but hopefully everyone will find some useful things to ponder:

I post my equity portfolio from time to time, but (at least at the current time, after my recent bouts of profit taking) it makes up a comparatively small part of my overall strategy. I was going to calculate the percentage distribution (probably will get around to it this weekend), but thought a discussion of diversification would be more helpful. Many people in the US (and maybe a few on METAR) were torn apart by the events which have taken place over the last year because of a lack of understanding of diversification. This was not necessarily their fault, but rather based on the propaganda disseminated by mutual fund companies (in fact they still publish this crap) which is a self serving process feeding into their profit motive. They make money by growing the pile of assets they manage, not by providing a fiduciary responsibility to increase the value of any of the funds.

Agree or disagree, but read on - I'm curious if this makes sense to anyone ?

What do we gain from diversification? Some of us are omniscient and can predict the exact thing to own to maximize our return at any given moment. For the rest of us mere mortals, we are as likely to guess wrong as right. To those for whom investing is a mind game, or those who commit a small amount, poor relative results do not amount to significant absolute results. To those of us who place significant funds into various categories, small changes on a percentage basis can have significant absolute ramifications. To put things into perspective, a .2% per trading day change can amount to a 40% change in price over the period of a year (if the changes are always in the same direction ?).

Oops, forgot - diversification was what I wanted to discuss. While I enjoy making money as much as the next guy, it is even more important to me to remember Warren Buffet's sage advice - "Never lose any money". OK, since all investments tend to involve risk, there is the possibility to lose money under certain circumstances. This makes guarantying adherence to Buffet's Rule problematic. Looking at the problem from this perspective tends to favor "mini-maxes" as the "swing for the fences" approach is frequently far riskier than an approach which would tend to have a lower potential reward, but a higher expected reward.

For those of you who have not run into the term "expected vale", simplistically it is determined by establishing the various likelihoods of all events and then multiplying the probability of each even by its value and then adding them all to get a single projected outcome. (Probably not the best explanation, but worth looking up and reading about).

Anyhow, rather than start with the potential classes of investment "stuff", I find it useful to list as many outcomes as possible, then ranking the most probable and assigning likelihoods to each (this is where you would try to identify potential black swans). Whatever outcomes you think are most likely is what you want to protect yourself against (or take advantage of). Each of these will affect different types of investments in a different way. The trick is to pick a mix of investment vehicles which maximizes the safety of your bankroll, while allowing for an acceptable rate (or absolute value) of return.

An example of what diversification is NOT: A variety of mutual funds of any classes of US stock, augmented by US bonds. This is two dimensional structure which could be easily toppled by a destructive influence in the US economy (‘nuff said here). Another problem could be caused by an over-reliance on physical gold in a portfolio. While it retains value, it may/may not be fairly valued at this point (don't forget it has appreciated faster than inflation for a few years and is now range bound), is awkward to store, protect, move in an emergency and even sell. If the dollar tanked and gold went up, would you ever sell it at a profit - likely you will be "in love" with it and hold it until it deteriorated in value again.

What are some of our future risks?

Drop in the price of the dollar
Increase in the value of the dollar
Our growth not being as robust as some other part of the world
High inflation
Low interest rates
High interest rates
Stock market declines
Bank failures

While the above list is not all inclusive, let's see how we can structure a portfolio which, without taking significant risks provides a reasonable probability of maintaining a positive return over the long run. Those who have read my ranting know by now that I am a "stock picker" and tend to only use mutual funds or ETF's for specific "niche" purposes. It is not rocket science to continually beat the S&P average for extended periods (is an AVERAGE after all - who among us is below average ? - if you don't believe me, plug my portfolios that I periodically post into your favorite tracker and see for yourself). That said, since many are uncomfortable with my comfort zone, I will use index funds for equities (low cost ways to equal market returns). I strongly recommend that before investing in any mutual fund, (other than say, some well run, discounted close end funds) that you carefully look at the expenses verses the potential reward and whether you can "roll your own" without the expenses.

Now let's see what should do well in each of the above:

Drop in the price of the dollar-foreign currencies, multinational US companies, foreign companies (reported profits will be higher in US dollars), commodities (subject to supply and demand)
Increase in the value of the dollar-US dollars (duh!), commodities drop
Our growth not being as robust as some other part of the world-foreign stocks will do well
High inflation-foreign currency, commodities (subject to supply/demand), US bonds go down
Deflation-US dollars, stocks drop, US bonds go up
Low interest rates-bonds are high, inflation unchecked
High interest rates-bonds cheaper, inflation is challenged
Stock market declines-timing issue
Bank failures-spread the wealth

The above is just an example, but a likely way to handle diversity is by a dynamic shifting of allocation rather than the more traditional re-balancing. In re-balancing, you sell some of what has gained and use the funds to buy what has declined until the ratios are back to the original proportions. In a dynamic allocation the proportions are changed as each category exceeds expectation of reward and before it gets affected by a decline. Once a category declines, funds are put back in (hopefully avoiding the painful experience of passively watching the destruction of your bankroll). The function of being diversified is to maximize the number of classes which are simultaneously rising at full funding while the declining ones have diminished (or no) funding.

Sample items in a diversified portfolio to address the above defined issues:

Bank account in Australia in AUD (6.2%), bank account in Switzerland in CHF (1.25%), (interest paying, domiciled on two other continents, hedge against drop in dollar, US inflation)
Bond ladder of newly "minted" (or discounted secondary market) TIP's in a tax deferred pension account (NOT mutual funds). These will protect principle if we have deflation and pay a premium if we have inflation.
Emerging market stock fund "coupled with" an emerging market bond fund to provide inertia (example: VWO, FNMIX) (Currently I believe the emerging markets will recover first and have higher growth than either the US, Japan or Europe).
� NASDAQ ETF (and or share with Russel ETF, but I think these will lag until we see recovery), ½ S&P ETF, ¼ DOW Ind ETF (Teeth gnashing as I type this ?). Stock timing is tricky, but basically buy low (but don't forget to sell high ?)

US Cash (While not much, can still get 2-3% in FDIC insured money market accounts).

(Timing thing) Since I think interest rates will rise in 2013 and short US bonds currently pay zilch, most US bonds are challenging to recommend to buy right now (and probably could be sold in 2012 if you currently own them). Municipal bonds of some states may make sense for those in higher tax brackets, but attention should be paid to safety.
Within stock portfolio, might augment ETF's with additional individual shares of such companies as BHP, RTP, ABX, NEM and GG with a bit of physical gold (physical gold is only useful in times of extremes - otherwise costs money to spend, store, move, and secure etc. - OK in moderation - otherwise a waste of potential return and flexibility.

Obviously there are more scenarios, more asset classes and a bunch of math that I won't bore you with, but with the constraints of allocation timing, a portfolio based on the above would behave reasonably well regardless of which of the above factors come into play in the future (with variations, and with the exception that I use individual stocks the above approach has worked for me for a number of decades).

Hope this helps someone,