Investment

Diversify and Conquer

diversification-investing

|True diversification should mean looking across everything we own and ensuring there is always something of value that can be monetized, regardless of the economic environment.|

Investing is not a zero-sum game. It is also a fallacy that someone else must lose money for you to profit. All the talk about “beating” the averages serves only to distract from the point, which is to generate a meaningful return on your investments while minimizing any risk of significant loss. Important and often overlooked is the ability to monetize those assets when you need them. This implies an investor should own a variety of assets, often referred to in the investment world as Diversification.

The notion that you simply have to have a specific number of stocks or mutual funds to achieve a “well balanced” portfolio seems to miss the point; especially when numbers ranging from 10 to 500 have been suggested by very smart people as what it takes to be diversified. Warren Buffett observed that too much diversification is difficult to manage (the actual quote is “If you have a harem of 40 women you never get to know any of them very well.”). The S&P 500 index gets its name from the number of stocks it holds – out of a possible 6000 equities found in an all-U.S. stocks fund.

Yet a laser focus on equity investments is to risk being not truly diversified. If all your assets are in stocks and/or bonds, what happens when financial markets swoon? Were you at all concerned about your stock portfolio during the market mayhem of 2009? On the other hand, if the bulk of your assets are gold coins stored in a safe deposit box what happens if the bank building is destroyed? If most of your assets are leveraged rental properties, what happens when you need cash fast? True diversity should mean looking across everything we own and ensuring there is always something of value that can be monetized, regardless of the economic environment.

One of the most successful family dynasties of all time, the Rothschild’s, have followed a very simple formula for diversification that has proven robust for over 400 years. It is just too easy to look at a stock portfolio or collection of rental houses while overlooking the many other things of value that you own, or that you can add to help create a truly diversified collection of assets. There is a benefit to working with the Rothschild model, even if just as a mental exercise, because it forces you to consider the bigger picture. 

  • One-third in cash; this includes equities, bonds, T-bills, exchange-traded funds, foreign currencies, certificates of deposit, and pretty much everything else represented by paper.
  • One-third in real estate; this includes a primary residence(s), vacation home(s), income-producing property such as ranches, farms, even raw land.
  • One-third in art and collectibles; this includes not just paintings and Egyptian antiquities, but jewelry (think gold, precious gems, wristwatches), furniture, fine china and flatware, a classic automobile, and pretty much any object that has a market value and can be sold.

Whatever your financial goals, follow your own instincts, not those of people who might view the world differently than you do. And don’t get distracted by what other people claim to be achieving. Remember, you don’t have to “beat” anything over time to create wealth. The only thing that really matters is the value and availability of your assets when you really need them.

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Investment

The Best Policy

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|The most important takeaway from today’s musings is the importance of having a personal Investment Policy to help guide your asset acquisition activities.|

About twenty-five years ago I wrote my first Investment Policy. The intention was to create a document that could help guide financial decision making knowing that my circumstances and goals would change over time. A recent review of that policy (which for a long time I referred to annually; not so much in the last few years) was rewarding and I share a couple of observations here. There were four parts to the original version that have been gently modified over the years. For our purposes today, only the first and second are discussed.

Part one of this investment policy consisted of three sentences intended to be touchstones under any circumstance and have never been changed. It still frustrates me I didn’t grasp the value of these ideas a decade earlier:

  • Spend less than we earn
  • Eliminate and eschew debt
  • Continually increase the value of our assets

Easy to explain the immense worth of these three. First, for most people what they save will be a lot more than what they make with investment speculations. Second, most financial traumas find their origin in debt. Finally, what ultimately matters is having assets that can be monetized when you most need them.

Part two was specifically intended for use when evaluating the merits of specific investments like stocks, mutual funds, and bonds. Later these concepts guided me in acquiring what has become the largest component of my portfolio, real estate (mostly physical but also by proxy in equity markets):

  • Being reasonable
  • The long-term
  • Diversification
  • A global perspective
  • Reversion to the mean

At some point, “Reversion to the mean” was replaced by “Black Swan events” something currently undergoing re-evaluation.

Over decades the equity markets go up more than they go down.

investment-policy-tech-dailyThe actual ratio is up about 60% versus down about 40% of the time. However, this does not hold true for individual stocks. After 50 years, less than 90 of the original members of the S&P 500 are still viable businesses. Over shorter periods of time, the valuation of any given business can vary wildly making it difficult to determine the mean price of any given stock. My frustration when trying to gauge when a stock has gone up too fast (growth) or dropped too low (value) led me to discount the merits of the “Reversion” metric. My heavy involvement in buying and selling rental properties in the half-dozen years before the sub-prime debacle also left me questioning this notion.

Side-stepping the mortgage fiasco of 2008-2009 by pure luck I was able to look (somewhat) objectively at what happened. A personal need to shut down a long-running partnership led to selling an inventory of a dozen rental properties at top prices in 2007 (all but one going sight unseen to buyers in California). This led me to understand very precisely what Nassim Taleb describes as a “Black Swan event.” While continuing to purchase income-producing real estate, I have not and will not re-enter the single-family home rental market.

The conundrum of “Reversion to the mean” versus “Black Swan events”.

So, the conundrum of “Reversion to the mean” versus “Black Swan events” has my mind moving back toward finding more relevance in “the mean” than Black Swans. Mostly due to some challenging reading over the last few years about theoretical mathematics my understanding of how to gauge the mean of a range of numbers has become more nuanced. A Black Swan is by definition unknowable and is best managed by a focus on “Diversification.” In other words, make sure you have a range of relatively uncorrelated assets to prevent a permanent impairment of capital if one of those asset groups becomes unexpectedly worthless. And don’t owe more money than you can repay in a cash crunch.

As for “Reversion to the mean,” it also needs to be understood in terms of “Diversification.” There are many metrics available to assess the value of equity and other investments. Looking just at the stock price (or selling price for real estate) is a risky business. Amply demonstrated by the technology big boys – Apple, Microsoft, Google – price-to-earnings may be a less valuable measure than price-to-sales. Maybe a change in debt level is a better context in which to think about a potential acquisition? When considering if something is worth adding to your asset collection, the exercise of analyzing a mean valuation is worth the effort. 

The most important takeaway.

Yet the most important takeaway from today’s musings is the importance of having a personal Investment Policy to help guide your asset acquisition activities. Without some guiding principles, it can be all too easy to get caught up in the madness of crowds or entangled in the webs of greed. Or, as described once as the lesson Warren Buffett offers us, “The pursuit of unchanging goals through ever-changing means.” Think about it.

 

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