Portfolio diversification: Positive or negative?

Negative

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by T.J. Wolfe

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Any investing theory was created in some type of market and pertains to the market that created it. An investment concept is rarely applicable to different markets. Diversification was a concept created during an extended period of rising markets. Diversification capitalized on the strengths of long term growth and stable markets. Long term growth and stable markets supported investing broadly in an index to reduce risk. The index was going up. The investor was guaranteed to match the index.

There is a difference. Today, the stock market is falling. If you follow any type of wave theory, the market has been falling for the last 8 years. It is inadvisable to use diversification in a falling or contracting stock market with high volatility. In fact, diversification would increase risk.

Diversification was a brilliant way of ensuring gains in a rising, stable market. Diversification enables the investor to match a benchmark index like the S&P 500 index and requires little stock knowledge. The investor buys a broad base of equities in the index. The broad base ensures returns similar to the index.

In the last six months most indices have posted losses of more than 50%. The investor who uses diversification is trying to lose 50% or more of their money. Most investors want to gain money in their investments.

The concept of investing broadly presents more problems. In order to match an index, the investor must invest broadly into the index. Investing broadly reduces the need to research and pick stocks. The number of stocks purchased would greatly exceed 20-30 stocks. Most investors have enough money to invest in three to ten stocks. They do not have the ability to diversify into an index.

When an investor can not diversify into an index, they need to know a lot about the index stocks. They also need to be able to compare stocks. Investors make sound stock picks through knowledge. The average investor does not have time to research and compare all the stocks in an index. This makes them an uninformed investor.

The stock market loves the uninformed. Every day, traders take money off the table from uninformed investors. An investor who believes they are executing a diversification strategy when they don't have enough money is a prime candidate to lose money to experienced traders.

In a falling market, the risk of losing money through diversification is guaranteed. The investor is guaranteed to match the index. Since the index is falling, so is your portfolio.

Diversific ation was created during a period of stable markets. The investor could invest for years and have few concerns. Today, the stock market is experiencing meteoric rises and falls. These rises and falls are coming faster and are more violent. There isn't any stability.

An example would be the year 2000 when the S&P 500 index topped 1500. A little over two years later, the index had tumbled to 827. It took decades to get to the first top. Five years later, the S&P 500 index had risen to 1567. A year and a half later, in 2009, the S&P 500 had plunged to 683. It took less than a decade to see another meteoric rise and fall.

Within these meteoric rises and falls, the action of individual stocks has become more volatile. Stocks that had been advancing for several months can show a sudden turn around and make a rapid descent to greater lows. Industries which were considered winning industries can become losers overnight.

A key strength of diversification is long-term investing. Holding a stock for years with today's volatility can almost ensure big loses. The large fortune 500 companies had been bell weathers of stability. Yet, the large companies are showing the greatest instability.

Another strength of diversification was that it needed little background knowledge.

Market volatility encourages the need for information. Many investors using diversification are trapped in the markets when the market starts to fall. In addition, they have too many stocks. They don't have a back-up plan because diversification didn't require knowledge in the markets. The volatility encourages uninformed investors to panic sell and buy. Panic sells and buys have an interesting way of creating exponential losses during a rapid descent.

Two financial instruments that have increased market volatility are: the expanded use of derivatives and the expansion of money supply.

Derivatives are a very complex subject. Yet, when you pull apart all the jargon, it comes down to something similar to a ponzi scheme where someone is left holding the bag.

Bernie Madoff was easy to understand because we could understand losing all our investment due to false reporting. Well, derivatives are not reported on the financial statements and are a potential liability. Derivatives are usually a single footnote in a 200 page prospectus. Good-luck finding it.

Just like Bernie Madoff, when the markets start turning against companies holding high risk derivatives, the company starts to fail. AIG is a great example of derivatives gone bad. The turn happens suddenly and most investors are caught unaware. The investor is left holding the bag.

Certain indices and industries have a propensity to be more heavily weighted with companies using derivatives. Accidentally diversifying into the indices ensures investors a high risk investment.

The concept of diversification was created at a time when the stock market was advancing. The goal was to obtain consistent returns over a period of years through a rather brilliant plan of investing broadly in an index. Yet, when the market is declining, the plan changes from consistent returns to a consistent loss. We work too hard for our money to throw it away on a concept that guarantees a loss.

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