From Wikipedia: In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors.
Basically, diversification is all about not putting all your eggs in one basket or else you risk breaking all your eggs at a go if you fall. However, one thing to note is that diversification does not increase your returns; it only reduces the deviation around your portfolio’s average returns. If you’re lucky (that is, a big IF), a narrow, concentrated portfolio could reap you a higher reward. This mentality is however, unwise – we seek certain rewards by taking calculated risk, not by gambling and seeking higher returns. If you want to gamble, you can always bring some money to the casino for some thrills. At the very least, if you lose all your money you brought along, you can call it quits and not risk your life savings.
There are many ways and degrees of diversification. Some books, for example, suggest that a dozen stocks are good enough. As we shall see from the Japanese and technology experience, even hundreds of stocks diversified over a continental force are often not good enough. Let us first review the Japanese experience.
In 1989, Japan was truly a Land of the Rising Sun. Its people are smart, hardworking and enterprising. From a war-torn era, they build a rich and prosperous continental force whose economy is second only to the United States in size. They designed and built cars and electronics products that thrashed their competitors’. Even patriotic Americans and ex-war rivals such as the Chinese bought better built made-in-Japan products in favor of their national products. In that epic year, the Nikkei 225 stock index hits an apex of 38,916 points. Japanese and overseas investors alike were hysteria. Having made some money from the stocks and buoy property market, they prophesy that the best is yet to be and Japan as a nation will rightly rule the world from a small corner in North-East Asia. However, the miracle was never to be and the economy plummeted. The stock market and land prices dived to unprecedented lows. Japanese investors who are fully invested lost their retirement funds. More than 2 decades later today, the Japanese stock market still has not recovered. At of 23 Jan 2012, the Nikkei 225 stands at 8765. If you were to invest at the Japanese peak, you would have lost a whopping 77%.
The other example I would like to quote is the infamous dot-com boom-and-bust. The dot-com boom era starts in the mid-90s. Internet companies such as Yahoo! and Amazon come into being and revolutionize the way we work and play. While Yahoo! and Amazon survived the era, there’re many other Internet companies with dubious business model which didn’t. They bankrupted when the funding went dry and brought the stocks investors down with them. An example is pet.com which sells pet supplies. The stock index that most closely tracks the technology sector is the US Nasdaq composite index. From a high of 5048 attained in 10 Mar 2000, it dropped precipitately to 1114 in 9 Oct 2002. Right now, more than a decade later, it still stood at a low of 2784 as at 23 Jan 2012.
Much has been talked about the 2 different eras. Some foresee the imminent crashes coming during their time. Tell-tale signs of the 2 bubbles are fundamental valuations such as the PE and price-to-book ratios. While valuations during most periods range from 10 to 20 for the PE ratios, many companies during those periods were out of whack in this regard. Some companies were valued at hundreds of times of their earnings. For the case of dot-com companies, the situation is even worse; most dot-com companies were burning cash and did not have a profit margin to speak of.
It’s now easy to view the bubble using the historical rear-view mirror. However, while we are in the midst of a major current bubble of our time, we tend to forget the norms and get too engrossed in the “next-big-thing”. Some of the more enlightened ones will see the light at the end of the tunnel but most will lose sight of the future and our gambler animal instinct will take over. We’ll ignore financial history and purge into the would-be bubbles head-first.
How should we avoid bubbles then? IMHO, the best way to circumvent the mania is to have a stable asset-allocation strategy that you can hold tight through thick and thin, whether the markets wane or bane is irrelevant. We first decide on the percentage we would like to allocate to stocks and bonds/cash. While the bonds and cash portion of our portfolio will have lower returns than stocks, they do a great service stabilizing the entire portfolio. By maintaining a fixed stocks/bonds ratio, we will convert bonds into stocks during years when stocks is doing poorly and exchange stocks to bonds when stocks have a bull run. This naturally results in a buy-low-sell-high cycle for stocks (buy low when stocks drop and sell high when stocks boom). Using the Japanese and technology bubble as an analogy, a discipline investor with a balanced portfolio of stocks and bonds would have offload at least part of the inflated stocks as the bubble become manic. As the stocks plunged into oblivion, the patient investor could now pick some of the equities at a deep discount and wait for the stock market to recover. Given the lower price levels the Japanese and technology stocks prices are right now, their future returns should be higher than when they are at their all time highs.
After deciding on the asset allocation strategy, we next decide on the stocks allocation. Most of us have a home bias. For example, an American will invest most of his/her stocks in American companies while a Singaporean will do likewise in a Singapore companies. However, as we have seen, this is full of problems. What happens if you were to invest your retirement savings in Japanese stocks in 1989? Of course, you’ll not be able to retire! The best strategy IMHO is to diversify as widely as possible – that is, to be globally diversified. The funds we invest in should best encompass all the major companies in the world so that when one economy or sector zigs, others might zag. There are a number of ETFs and Unit Trusts (mutual funds) in Singapore and US that index the world stock markets. Such funds are frequently large and have low expense ratio. Be sure to check the prospectus that they are index funds so that there will not be tracking errors from the world economy and the fund managers will not have leeway to speculate with your money.
Investments are all inherently risky. But, if we diversify prudently and wisely, we should be able to lower non-systematic risks while enjoying the fruits of calculated risks.