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The truth about “diversification.” September 26, 2011

Posted by shaferfinancial in Finance, Uncategorized.
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In my mind, diversification is fools gold. It looks good, all shiny and glittery, but in reality is worthless as a financial concept. First of all in its original form, it really means diversifying asset classes. That is if one asset class is doing badly it is less likely that 2 are doing badly and even less likely that three are doing badly, etc. But most people are only invested in equities or equities and bonds. Two asset classes are better than one, but that is hardly real diversification.

Most financial planners apply it to equities. On that you reach the vast majority of risk reduction owning 20 stocks. But most planners suggest owning a variety of mutual funds that might hold hundreds of stocks in each one.

What is wrong with this you might ask?

Well that leads us to the point most financial planners don’t understand or won’t explain to you. The way diversification works is it lowers overall variance. Meaning that owning one stock the total variance in any given year might be -100% [total loss] to let’s say 1000%. So a total variance of 1100%. Owning more than one lowers the risk of total loss. It also lowers the ability of choosing that home run stock. So lets say the possibilities are from -60% to 150% or a total variance of 210%. But here is the part they don’t tell you. It also lowers expected return. Diversification costs! Many people might say it is worth the cost to not have a total loss of funds. OK, but why diversify stocks to the point of owning hundreds or even thousands? Why not diversify asset classes?

But the bottom line is always how does all this theory do in the real world. And here is where it really fails. In the real world there always comes a time that the principal is needed. And this risk is rarely explained to folks. If you need the money within a few years before or after a major negative event you might never make up your losses. That is because you are spending the capital and therefore need a lot of time to make it up. Time you probably won’t have.

Mutual funds, the major financial tool most people have been told to depend upon are possibly the worst investment vehicle for retirement income because they don’t produce income. Bottom line is you have to sell the asset to get anything out of them. Selling into a down market is the worst thing you can possible do. All that diversification did not protect you one iota from the real risk.

So next time some financial expert starts talking about diversification ask them about what happens when a market downturn occurs during your retirement years and you have to draw down your account significantly. Or ask him what happens if you retire into a 10 year period like the last 10 years. And then go find out about dividend producing stocks or an EIUL or investment real estate all of which solve the issue in their own way.



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