Diversification: Giving up some home runs, to avoid future strikeouts

We love Carl Richards money doodles on the New York Times ‘Bucks’ blog, but missed this gem of a post he had at the end of last year (literally..on Dec. 31). The topic – diversification.  The angle – diversification isn’t all roses and candy canes. It’s hard to stick to because it involves giving up something (hitting home runs) in order to get something (never striking out).

Diversification bubbleDoodle Courtesy: Bucks Blog via The New York Times

At a time when stocks are at all time highs and managed futures feeling as though it’s at all time lows – it sure pays to remember what they’re doing in the portfolio – so you don’t strike out. But we’ll let the man speak for himself:

The idea [of diversification] is to balance… investments in a way that gives up some higher returns in exchange for lower overall risk. Essentially, you’ve given up the opportunity to hit home runs for the benefit of never striking out.

With that out of the way, let’s talk about the risk of diversification.

Whenever you diversify, if you’ve done it correctly, there will always be something in your portfolio that you’re in love with and something that you want to dump (or will at least be the source of concern, as bonds are now in some circles). Some investment or asset class will be doing fantastic compared to the rest of your portfolio, and something will be doing much worse than everything else.

The trouble is, you never know when all of this will change. The thing you want to buy more of now will someday become the thing you want to sell.

But here is the point. The risk of diversification is that you will bail on it as a strategy at exactly the wrong time.

That feeling you get — the one that says, I wish I could dump this lame investment so I could buy a whole bunch more of this incredibly hot one — can get you into trouble fast. The temptation is greatest when it would be the most catastrophic for you to succumb.

But that feeling is actually telling you that you’ve done the right thing: You’re diversified. So remember that when the current fad ends and today’s rejects come back into style, you’ll be okay. And you’ll be awfully glad you didn’t give in to the temptation to give up on being diversified.

The next time diversification appears to not be working, remind yourself that it is a long-term strategy that can’t be judged on your short-term experience. In other words, just because something isn’t working right this minute — or even right this year — doesn’t mean it’s broken. So instead of thinking, “I am a rocket scientist and I can come up with something better,” just let diversification do its job.

Then go for a hike in the mountains instead of sitting hunched over the sell button on your broker’s Web site.”

 

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