Lessons Learned #1 - Diversification

In the coming weeks, I plan to write a series of thoughts on what we should have learned from the current financial crisis, keeping it direct and to the point. Lesson #1 is Diversification.

Diversification is defined as the process of reducing risk by spreading investment risks across various asset types and tenures. In the case of personal investments, diversification means, to use an old adage, "you don't have all your eggs in one basket". It essentially says a good investor does not get too greedy.

Asset types include stocks (equities), bonds, real estate, collectibles and antiques, and cash (or cash equivalents). A diversified investor has spread his/her invested dollars across many, if not all of these categories.

Diversification also speaks to the tenure or maturity of the investments. In the case of bonds or certificates of deposit, a diversified investor has "laddered" or structured his/her principal repayments so that all of the money is not repaid all at one time. This helps manage interest rate risk or the risk that the investor has too much of his/her money come due in the same period of rising or declining rates. In other words, you do not want all of your investments to re-price at the same time.

A diversified investor has also considered liquidity. Liquidity speaks to the time it takes to convert the asset into cash, particularly in the event of an emergency. A diversified investor has some less liquid investments like their home and some very liquid investments like cash in their portfolio.

Let's use the Madoff fund as an example. The investors reportedly obtained a near-12% return routinely, despite the regular gyrations of the stock and bond markets over time. Investors with Madoff often put all of their invested dollars with Mr. Madoff (or increased their concentration of investments with him) because of the high rate of return and its consistency. In the future, I will talk about the lesson that "if it appears too good to be true, it is", but as investors increasingly over-weighted their investments with Madoff due to his routinely high returns, the same investors were later burned by their lack of diversification. While sympathetic to the widows moving in with their children because their nest egg is now lost, the lack of diversification is in part a flaw in the victim's investment strategy that helped Mr. Madoff destroy all of his investor's net worth in many unfortunate cases.

Will diversification then lead to lower returns? It might in the short run. A mix of bonds and equities is desired in any investment portfolio. Over time, bonds have been outperformed by equities because there is greater risk associated with equities and therefore, at times, they pay higher returns (or else no one would buy a stock). Bonds pay lower returns because, in the case of a bond issuer's bankruptcy or default, the bondholders get repaid with any remaining funds in a business before equity holders. Therefore, the probability a bondholder gets nothing for an investment, even in default, is lower than the probability a stock goes to essentially $0. Bonds also pay interest, a form of return, unless the bond issuer defaults. Stocks may pay dividends, though dividends are not guaranteed.

Diversification should match your age group and/or your investment goals. A young person with 35-40 years of employment earnings ahead of him/her can take more risk because he/she can earn money lost in the markets over their remaining working lives. A person in retirement may have no sources of income outside of pension and social security and a shorter expected remaining lifetime. There might not be time to earn money lost in the stock market, even in a soaring stock market. I think of my in-laws who had a money manager who had them too focused on equities. Last fall, they lost a quarter of a million dollars in their investment portfolio because not only did he have them too focused on the stock market, but he also had them focused on bank stocks.

Not only should there be a mix of bonds and equity, but there should be a mix of different kinds of industries among the bonds and stocks an investor holds. Jim Cramer does a skit on his Mad Money show about "am I diversified?" While cartoonish, the lesson is a good one. If you own 5 stocks in your portfolio, each should represent a different industry - for example, a bank stock, an industrial company's stock, a tech stock, a healthcare stock, and maybe an agricultural company's stock. On a macroeconomic basis, the stock market will move up or down en masse often, however, there will be stocks that do better than others so the investor will get a range of outcomes.

Liquidity is also increasingly important today because banks are not lending. A main source of liquidity for many is their credit card(s). If you had a major bill, like an unexpected medical expense, you would probably pull out a credit card to pay. Given the recent moves by Congress to rein in a number of questionable practices by credit card issuers to adjust fees, interest rates, billing cycles, etc. in response to changes in a card holder's financial situation (or the issuers' assessment of the change in risk), credit card issuers will likely reduce their mass marketing of credit cards and/or will charge higher rates, offer lower credit lines, and will increase annual fees on a proactive basis in advance of the enactment of the legislation. Many consumers report having their lines cut already. Will you be able to turn to your credit card in an emergency? If not, do you have cash savings (or investments that you could and would sell to raise money) for an emergency? Most do not have 3-6 months of income saved for a "rainy day".

Liquid assets do not need to be cash - they could be "in the money" stocks, CDs, savings accounts, money market accounts, and other items that can be sold within a day or two. And some might be sold at a small loss - but that is a price for liquidity.

Real estate and collectibles are examples of non-liquid assets, for the most part. There is a market for real estate and there are places, like flea markets and antique dealers, where you can sell your grandmother's hutch for cash, but some planning is involved and a hurried sale could result in a greater opportunity for a loss on the investment. A "quick sale" is a method of selling a house in order to discharge part of a mortgage. This is an alternative to foreclosure but typically, because the sale is in haste, the sale amount does not cover the mortgage balance. A more deliberative sale could allow the seller the time to select the bid that more closely approximates the value the seller has placed on the home - even if it takes years.

One lesson learned from the financial crisis is diversification. A smart investor will regularly review his/her portfolio to ensure that all of the goals of diversification are met - no undue concentration in any asset type, in any tenure of investment, and in any investment sector - and a consideration of liquidity in investments. There is no one "right or wrong" answer for an investor but diversification should keep in mind possible losses and the remaining time the investor has to recover losses.

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