Importance of Diversification
Posted by Frugal on July 22nd, 2006
How many times have you heard a successful wealthy person had their fortune reversed on him/her and fallen all the way down? Although this kind of story happens mostly to business owners and some investors, understanding the causes will help you greatly to avoid such scenario, even if your networth is on a smaller scale.
A lot of such stories go like this.
- Start-up: The business owner started small in something.
- Ramp-up: He/she was at the right place and at the right time, and good things start to happen one after another.
- Peak: He/she was very successful, and with one final investing bet, or one final big expansion at the peak of his/her business, things start to go against him. (Of course, the term “final” can only be seen from hind-sight, and post-peak.)
- Downturn: Because of his/her over-confidence and over-leveraging at the peak, everything simply crumbles down so much faster when luck does not work in his/her favor. He/she lost almost everything to the line of the business or investment from exactly where he/she gained those wealth.
Now if you observe the above sequence carefully, there are three major reasons that he/she cannot preserve his/her wealth.
- External factor: Business and investment go through cycles of up and down. It’s seldom a straight line up.
- Internal factor: A person gets over-confident, and instead of realizing that a significant factor that contributed to his/her success is because of the business/investment cycles, he/she thinks that he/she is the major if not the only factor to his/her success.
- Leverage: A leverage works both ways. Going up, it’s terrific. And just when you think that it cannot possibly go down, it goes down and eats you alive, 2X or 10X faster, depending on the amount of leveraging factor that was used.
What are the key lessons that one can take away from this?
- Understanding the business cycle is extremely important.
- Diversification of one’s networth or investment or business among different un-correlated sectors will prevent a big downturn cycle in a particular sector to wipe out one’s entire stake.
- Use leverage extremely carefully. It’s a dual-edge sword.
I will post more on business cycle in respect to stock investment. However, no one can have a clear crystal ball everytime or every moment. It is far better to diversify your assets somehow, and make gradual shifts depending on the business/investing environment. Without diversification, you will need to rely on being close to 100% correct, and run the big risk of giving it all back, going from 0 to 100, and then back to 0 (and some more if you use leverage).
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July 22nd, 2006 at 11:03 am
Interesting post and topic! Diversification is a good advice. The danger is when you are really into something and making good money you become obsessed with it and you do not worry about these “boring” issues.
July 31st, 2006 at 6:01 pm
Do you really think that diversification helps? It seems to me to be a defense against ignorance. If you can distinguish between a good investment and a bad one, isn’t it better to be concentrated in the few best investments that are available? Your example seems to be more an example of how even a good investment, but especially speculative ones such as startups, can actually become overvalued, or simply turn out to be poor investments. A good investor should be able to identify these conditions early, especially if he has control, and look to reduce his exposure to that specific investment. Of course, if he is a founder, the investor is likely to find selling to be difficult.
July 31st, 2006 at 10:06 pm
Doug,
If you think you can identify the good ones from the bad, with 100% certainty, then you will probably go down in history as the only prescient guy. No one has ever been able to consistently make such identification with 100% certainty. If you can do anything with certainty for even 10 seconds, and prove such, you can borrow 10 trillion tomorrow or as much as the market liquidty can afford, and just bet for that 10 seconds to extract some 0.1% value, and get your 10 billions in 10 seconds.
Diversification is indeed the defense against ignorance, because no one can simply be sure of everything at every moment. Diversification is a self-acknowledgement of one’s own ignorance to the future events. Of course, this is not a black & white issue either. The more certain you are, the more you should concentrate your assets into the desired allocations. The less certain you are, the more diversified your money should be. In the case of index investing, you’re simply taking the market average without adding anymore of your own opinions.
Time after time, the only true defense against unknowable events is diversification. You should really read The Four Pillars of Investing. There is close to zero mutual funds that beat market index in an extended time-frame. Tens of thousands of smart money managers cannot beat the market on a consistent basis. That should tell you something.
June 6th, 2009 at 5:15 pm
Hi Frugal,
Mutual Funds do not outperform the market on a consistent basis because of two reasons:
1. Regulations which require them to maintain a minimum exposure to the market, and
2. Buy-and-hold (aka Buy-and-hope) fundamental analysis driven investment strategies
However, there are many hedge fund managers that do outperform the market CONSISTENTLY. I encourage you to read Michael Covel’s books, “Trend Following” and “The Complete Turtle Trader” for detailed records and strategies of Trend Following technical traders, this is the investment philosophy I follow, and the most balanced and objective in my opinion.
I believe you should never risk what you absolutely cannot afford to lose. People need to stop thinking about getting rich quick, and think about how to consistently grow their assets by taking calculated risk – focusing on the process and not the result, but using the result to optimize the process. You mentioned that Leverage is a double-edged sword, so is Diversification. It not only protects your assets from risk, but it dilutes their potential gains.
My personal philosophy is that of Robert Kiyosaki’s. Every one says “Don’t put all your eggs in one basket.” But, you shouldn’t put a few eggs in many baskets either, rather, you must place many eggs in a few baskets. You have to find that optimal, focused level of diversification depending on many factors including investment goals, risk aversion, and proper risk analysis of the asset classes in question.
Thanks for a great blog!
Cheers,
Muaad