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What is True Diversification?

March 5, 2007

This week we take a look at one of the more common problems I see as I counsel investors, a lack of diversification. Much of the time that stems from not having a philosophy of investing and defaulting to simple selections that over time can create problems when those selections run into a bit of volatility.

Good friend and successful money manager Gary Marks gives us some thoughts on diversification. Gary has written a book called Rocking Wall Street that is the first in what I hope is a series of books with the Millennium Wave imprint. I have written the forward to it. The book is extremely useful in helping you develop a philosophy of investing that will weather the test of time, as well as explain specific strategies and techniques for creating your own diversified portfolio that will help you balance the risk and rewards of the markets.

At least some brokerage firms are clearly not happy about Gary's book. A highly complimentary statement about Gary's strategies by a senior portfolio manager at a major brokerage firm led that firm's compliance department to issue a written warning to Mr. Marks not to use his quote to promote the book.

Why is this book rocking Wall Street? In this edited excerpt from the book, Gary touches on some of these controversial points, such as what if traditional diversification models were debunked as too risky
and ineffective?

You can (and should!) get your copy of this well written, easy to read book at http://www.amazon.com/exec/obidos/ASIN/0470124873/frontlinethou-20.

And now, let enjoy today's Outside the Box.

John Mauldin, Editor
Outside the Box

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What is True Diversification?

Playing with the stock market is like playing chicken with a freight train... no matter how many times you win, you only get to lose once.

-Mike Masters

The most commonly known way to hedge a portfolio is to diversify your investments. However, when all the investments are based on the upward trends of various markets or stocks or the fiscal safety of corporate bonds or foreign countries, then diversification actually decreases.

Why? Because all of your assets are betting on uptrends and/or the well-being of the global landscape. And neither are reliable bets.

Underestimating the difficulty of diversifying a portfolio is very common. But the biggest mistake investors can make is betting their financial futures on a single stock, sector, concentrated theme, or asset class (that includes the darlings of generations past and present--gold and real estate).

Even bonds have volatile cycles and trends, despite their often tepid annual returns.

Investors usually make the assumption that they will have the staying power to wait out bear market losses in their investments. But that waiting period often takes many years; sometimes it takes many decades. During that time, individuals and families often lose fortunes.

Very few investors have the financial or psychological capability to sustain themselves during those violent down cycles. The average secular bear market in the U.S. equity market in the twentieth century was 17 years.

During the years 2000 through 2002, many investors found their 401(k) and private portfolios incurring serious losses of 20 percent to 50 percent of their assets, despite thinking they were safely diversified with a mix of bonds and equities.

Importantly, if the next bear market is an inflation-generated bear market, bonds could lose a great deal of their principal and/or not keep up with inflation. Although noncorporate bonds saved some investors from total disaster in 2000 to 2002, they may not save those investors next time.

Every bear market has a different set of booby traps. It is almost impossible to set up a traditional portfolio that prevents serious losses when bear market cycles run their course.

Here is a list of diversified indexes and asset classes that were all down from their historic 1999 or 2000 highs by the end of 2002.

Russell Small Cap Index -36%
Dow Jones Industrial Average -38%
S&P 500 -49%
NASDAQ -78%
Gold Index -64%
Biotech Index -66%
European Index -63%
Asia Index -58%
Brazil -58%
Argentina -70%
China -52%
India -58%
Japan -61%

--- Of course, this was before the February 27th decline in the world markets. The reaction to China's 9% decline was this:

Russell Small Cap Index -3.77%
Dow Jones Industrial Average -3.29%
S&P 500 -3.47%
NASDAQ -3.86%
Gold Index -7.16%
Biotech Index -3.69%
European Index -4.11%
China -9%
Brazil -6.63%
Argentina -7.49%
India -4.01%
Japan - 2.85%

Let's also look at the "classic" bond / equity split scenario of 60 /40 equities to bonds as an example:

An investor during the above 3-year bear market period whose portfolio was holding 60% S&P index (by far the best performer of the above indices over that period) and 40% bonds would have had a 3-year total return of about -16% (using the Lehman Aggregate Bond Index from 2000-2002). This is a pretty nasty return for someone who would typically be called a "conservative" diversified investor (broader diversification from the above list would have further weakened returns

ONLY owning bonds, by the way, using the same index as representation, would have averaged returns of about 3.8% a year before tax during this latest bull market. So it's clear owning only bonds would not be the answer for most investors.

The bottom line is this:

If / when the global economy has its next secular downturn are you going to be fiscally solvent enough, and emotionally capable enough, to stay with your present "diversified" investing strategy? And that assumes you will live long enough to ride out the downturn, which sometimes takes a decade or longer.

Or, will you end up trying to "time out" of the market out of desperation? (Statistically a loser's game with stunning odds against you.)

If the answer is yes, you will stay the course and keep your portfolio as is, you are either rare among us, or maybe when the time comes -- let's just say emotions are a funny thing.

If your answer is no, you can't fiscally or emotionally afford that kind of risk (especially since no one knows how much worse things can get after you've already lost a great deal of money), then you probably should consider re-evaluating your investment strategy sooner than later.

Statistically one thing is clear - traditional means of diversification won't save you.

So WHAT IS TRUE DIVERSIFICATION?

Much to the chagrin of the investment houses and its brokers, true diversification includes far more investment choices than just stocks and bonds. It includes other non-correlating asset classes that don't intrinsically encompass either speculation or timing. It would also include alternative investment opportunities for those who are qualified investors.

With each investment be sure to invest no more than you can afford to lose, so you can sleep at night. And use dollar cost averaging - taking a percentage of your annual personal savings each year to add to your investment holdings, so that volatility becomes an advantage over a long time horizon.

Only then will diversification begin to make statistical sense.

---

Thanks Gary, for those thoughts. Remember, you can (and should!) get your copy of this well written, easy to read book at http://www.amazon.com/exec/obidos/ASIN/0470124873/frontlinethou-20.

Your suggesting you get this book analyst,

John Mauldin

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