What does diversification have to do with Twinkies and natural disasters?

When people invest, their thinking quickly goes from prudent planning to chasing the latest investment that is going up. This often results in the opposite of diversification through chasing returns and market timing.

When you invest, you invest in businesses in general. Yes, municipalities, state and national governments also seek financing by issuing bonds of one sort or another too. Rather than focus on very limited areas, a prudent plan takes a global perspective.

Look at all the natural disasters that occur across the globe any given year. Superstorm Sandy is the latest to hit the U.S. Earthquakes hit many different countries yearly too. Each natural disaster results in disruption in business locally and regionally. Thus, in the case of Superstorm Sandy, rather than just invest in companies in the upper Northeast, a prudent plan would invest in companies spread out across a broader region. How broad? How about globally!

Think of investing as designing a cable. The more strands there are, the stronger the cable. Each tiny individual strand may represent a company in my metaphor. More strands results in a stronger bundle. Each bundle of strands may represent a sector in the economy. Each group of bundles may represent a market dimension. Think of each of the large bundles as an index fund. The final cable is the result of winding all the bundles (many different indexes) around themselves for maximum strength … the more the bundles (indexes), the stronger the cable (portfolio). Thus, the more indexes you have, the stronger your portfolio.

Yes, things happen in nature regionally. Things also happen in sectors of the economy. But a totally global construction requires all the businesses to go out of business simultaneously … much like a global disaster that covers all regions of the globe … possible but unlikely (and if it did happen, there would be nowhere to hide anyway).

9 passively indexed mutual funds are like 9 key dimensions that make up 9 different bundles in a global cable metaphor. There are 11,340 total holdings* (strands in my metaphor) spread out across the globe. Once a portfolio has been constructed in such a way, the important aspect becomes dialing in the mix that most closely aligns with your risk and return profile instead of chasing returns as those returns constantly shift over time.

The overall result of such an approach is to shift your focus to how to meet the goal you have for your money, and not chasing after each strand and try to make your own cable bundles on your own.

The goal of a cable is to support the weight of a bridge for example. The goal of your portfolio is to support the weight of your future spending from that portfolio. A proper portfolio structure holds together in both good times and in bad times, just as the cables hold the bridge up in both good and bad weather.**

Once you have prudently constructed your portfolio, how do you measure your progress toward your goal? (Note: the links at the bottom of the article in the next blog walk you through retirement planning … both pre- and post-  ).

 

*Data source as of 30 June 2012 in 9 SA Funds. This is not an offer or solicitation of these funds; simply an example of the metaphor cable strands as fund holdings. Retail index funds may also be used however the number of holdings may be less. **Diversification does not prevent loss of portfolio value. Broad indexing  may still have portfolio value even though some of the holdings within the index go out of business during market declines. Investing directly in an index is not possible, thus indexed funds were developed.

 

PS. Tying lots of current events together in this metaphor:

The Fiscal Cliff*** may be an example of focusing on just one region (the U.S.) rather than globally. Yes, there are problems around the world, but there always have been. Having exposure to many different things allows rebalancing to work. Not everything goes up all the time. Sometimes everything goes down.

People often are not concerned about the bridge holding up when the weather is good. They get concerned when the weather is bad. In truth, a properly constructed bridge is not built for good weather … it has already been designed for the bad weather. A properly constructed portfolio should be built and designed in the same way.

Diversification means that you are not totally exposed to something that may go to zero value (like Twinkies of late (International Food (Hostess), ticker IFCO, an example of a strand that snaps, founded in 1930 and gone in 2012) even though everything else may be going down at the time too. With broad diversification, your portfolio doesn’t reach a zero value until everything in the portfolio is out of business.

 

***There’s little agreement if it is a cliff or not.

 

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