Investing Caffeine

Your Investment Car Needs Shocks

May 9, 2009 at 3:14 am 3 comments

Smooth Out the Bumpy Ride

Investing can make for a bumpy ride. What can investors do to smooth out the rough financial journey? The simple answer: diversification. If you consider your investment portfolio as a car, then the process of diversification acts like shock absorbers. Those shocks make for a more comfortable ride while preventing potential disasters – like accidentally driving your investments off a cliff.

People generally understand the concept behind, “not putting all your eggs in one basket.” However, once introduced to financial theory terms such as correlation, covariance, and the efficient frontier, people’s eyes begin to glaze over…and rightfully so!

So what are some of the key points one should understand regarding diversification:

• Lunch CAN Be Free! There are very few free lunches in life, but with “diversification” you can indeed get something for nothing. For example, let’s assume you are approached with two investments, ski hats and sun visors, and each investment is expected to deliver a 5% annual return.  Furthermore, let’s suppose that zero ski hats are sold in Spring and Summer (and zero sun visors in Fall and Winter). If you merely own one investment, that investment will be more risky (volatile) than a combo portfolio for half the year. Although any combination of two investments will create a 5% return, by diversifying (owning both investments), you can smooth out the ride. There’s your free lunch – the same return achieved for less risk (volatility)!

• Gravity Holds True For Investments Too!  Nothing goes up forever, so do not concentrate your portfolio in sectors that have wildly outperformed other sectors/asset classes for long periods of time. Lessons learned over the last 10 years in the areas of technology and real estate highlight the dangers of over-exposure to any one sector in the economy.

• Vary Your Investment Diet! In the Oscar-nominated documentary Super Size Me, Morgan Spurlock decides to eat McDonald’s fast-food for breakfast, lunch, and dinner for thirty days. As a result, his cholesterol levels sky-rocket, he gains over 24 pounds, and his liver function deteriorates significantly. When it comes to your investment portfolio, you should balance it across a wide range of healthy options, including domestic and international stocks and bonds; large and small capitalization stocks; growth and value styles; cash and low-risk liquid investments; and alternative asset classes, such as real estate, commodities, and private investments.

The benefits of diversification will fluctuate under different economic climates. During our recent financial crisis, especially in late 2008, the correlation ratio (the degree that different asset classes move together) unfortunately was very high. However, those investors who were exposed to areas such as Treasury securities, gold, cash, and bonds generally fared better than those who did not. Subsequently, in the early part of 2009, the benefits of diversification shined through as outperformance in emerging markets, technology, consumer discretionary and growth stocks balanced the weakness suffered in banking, transportation, healthcare, bond and value segments.

Diversification helps on the rough roads of investing, so make sure to check those shocks!

Entry filed under: Asset Allocation. Tags: Asset Allocation, diversification, investing, Investment Strategy, Picking Investments.