Many of you may not know that in addition to being a financial advisor, I am also a professional freelance photographer. When I photograph a wedding, I take two cameras, a wide variety of lenses, at least two of each kind of light, and four light stands. Wherever possible, I have at least two of everything, and sometimes more. It makes for a large and heavy kit, so I pack everything in wheeled cases.
The reason I do this is because things break, and they are most likely to break when you are using them. To state that another way, things rarely break while sitting in my house waiting for the next wedding. They break under stress.
In short, redundancy is how I deal with surprises while photographing a wedding.
Over my many decades as a financial advisor, one of the top questions I am asked is how I would deal with a disaster. Some people actually imagine that as a professional, I am somehow able to know when disasters are coming before they arrive and able to take measures to avoid the danger for my clients. I wish that were true. If I could see the future that clearly, I would probably be wealthier than anyone in history.
The truth is, it’s almost impossible to see disasters coming. Disasters are often the result of a surprise. And the very definition of surprise is that we don’t see it coming.
Unlike in wedding photography, preparing for the inevitable unpleasant surprise can’t be done by having two of everything. If you have shares of ABC Widgets, buying additional shares of ABC Widgets won’t help you in the event of an unpleasant surprise. It will only make you more vulnerable to it. Buying shares of their direct competitor, DEF Widgets, only helps in the event of a company-specific problem over at ABC—say, an accounting scandal or some other internal issue. It doesn’t help you if widgets become obsolete or demand drops due to recession.
Interestingly, while redundancy is no help in investments, its opposite is. With each step of further diversification, we get a little more ability to manage the risk of unforeseen events. If we own both ABC and DEC Widgets, we have some potential help in the case of internal problems at either company. But if we also own shares of companies in other fields, we get still more diversification. And in investments, the more diversification you can get, the better.
There’s some math for this. By measuring the historical correlation between different types of investments, we can see what, if any, help we might get from different forms of diversification.
Stocks in different market sectors have different correlations with each other. Bonds tend to be still less correlated with stocks. And if our goal is diversification, then less correlation is better. Less correlation means that when one thing is dropping, something else is going up, creating a smoother ride.
Here are a few more thoughts about diversification.
- As with almost everything, there’s such a thing as too much diversification. The disadvantage of diversification is that the cost of managing your downside may also keep you from growing at a rapid rate.
- The superwealthy often got their wealth from a single company or investment that went wildly well. If you are very well diversified, then the impact of something going wildly well has been diminished. But that’s also the point, because the impact of something going wildly bad is also diminished.
- Rebalancing is important. Let’s say you start out with all of your money equally divided among four different investments. Over the course of time, one or two of those investments will do better than the others. This will cause your percentages to drift. So at the end of a year, you might have 28 percent in one thing and 22 percent in the other. You might choose to leave that unadjusted. In other words, if investment A is doing better than investment B, why would you rock the boat?
Because very often these two will converge again. Investment A may stagnate or even decline, while investment B may do better for a while. If at the end of that year you sell some of investment A to reduce it back to 25 percent of your portfolio, and use the proceeds of that sale to buy more of investment B, most of the time that decision will enhance your overall returns.
It can be emotionally difficult to sell what’s working so well. But when you think about it, isn’t this just a small way of buying low and selling high? Isn’t that what you want to do?
Rebalancing doesn’t always work out, but it does often enough to make it worth considering.
So this is my answer. I don’t try to predict surprises. I feel silly even writing that sentence. I use diversification to manage the risk that often comes from surprises.
Hal Masover is a Chartered Retirement Planning Counselor and a registered representative. His firm, Investment Insights, LLC is at 508 N 2nd Street, Suite 203, Fairfield, IA 52556. Securities offered through, Cambridge Investment Research, Inc, a Broker/Dealer, Member FINRA/ SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Investment Insights, Inc & Cambridge are not affiliated. Comments and questions can be sent to hal.masover@emailsri.com These are the opinions of Hal Masover and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.
Indices mentioned are unmanaged and cannot be invested in directly.