Why Diversification Can Reduce Risk
Diversifying can mean more than just adding to your business repertoire.
October 19, 2011 By Jim Sanderson
Diversifying in business is often a way to manage or reduce risk as well as a way to boost revenue.
Diversifying in business is often a way to manage or reduce risk as well as a way to boost revenue. You can smooth out your cash flow by adding new products or services and should the demand for one service decline, you are not dependent on that one service to carry you through as other services are now bringing in revenue. Perhaps your business is vertically integrated by buying that gravel pit and your business is now fully diversified from raw material to the asphalt plant.
Protecting Your Work
You obviously want to protect the results of years of hard work you (and perhaps your family) have put into your business. That is why we advise business owners to put the effort they dedicated to their business plan into an equally detailed investment plan – and the sooner the better.
The heart of this strategy involves setting up a personal investment portfolio outside the business. When you retire and will no longer rely on your business to generate personal cash flow, wouldn’t it give you peace of mind to know a well-diversified personal investment portfolio will fund a long retirement?
Quality of Life
I have spoken of the value of a succession plan designed to help you better manage the outcome of your retirement. Having an investment plan outside your business is a critical piece of your succession plan that will affect your quality of life going forward.
Regardless of your stage in life, it’s safe to say you would rather look forward to retirement versus being forced to sell the business at a discount because there are no assets other than the business on which to rely.
A number of my clients will retire in the next 10 years. Some are looking forward to retirement, but others may be forced into retirement for a variety of reasons. We can’t control the event or combination of events that leads them to retire but we can help to control the outcome of their retirement.
When the time comes to sell your business or pass it on to the next generation, having enough capital outside of your business to fund your retirement makes this lifestyle change that much easier. If you sell your business to your children or a third party and your retirement is dependent on the health of the business, your standard of living will be dictated by the company’s ups and downs, which does not make for a happy and stress-free retirement.
Generating Investment Income
It is important to realize that generating investment income is different from producing business income. Generating business income is opportunistic in nature, where you try to anticipate changes in the marketplace and put them in place – before your competitors. If you get it right, you do well and are rewarded for risks you have taken.
Making sure you enjoy the quality of returns that reflect the level of risk you assume is critical to creating both investment and business income.
Investors are occasionally rewarded for picking the “right” stock or fund. Some Canadian stocks have soared in price and then fallen just as quickly, often when the investors thought it was safe to imbed them permanently in their investment portfolios.
For these investors, creating investment income can become a hit and miss process, as they chase the hottest stocks one day and then doggedly stick to the handful of investments they have come to know and trust, the next.
Diversification in an investment portfolio is just as important. No one can predict the future. It is, in fact, borne out by more than 60 years of research confirming investors’ overall lack of success when they choose individual stocks in a few sectors or countries versus investing in a broad range of stocks, thus diversifying their investment portfolios.
That is the point of a book entitled, The Quest for Alpha by Larry Swedroe*, a universally recognized investment expert and author of 10 books on investing. Many how-to books, blogs, radio shows and other forms of entertainment attract lots of investor attention, promising positive results for readers who follow a system when investing in everything from highly speculative real estate ventures to the day’s hot penny stock. But this book is based on investing science, where science does indeed trump fad.
Clairvoyants Can Look Elsewhere
“Modern Portfolio Theory” (MPT) is the name given to the 60-year-old scientific and objective approach to amassing wealth. It is also the foundation of Swedroe’s (and my) investing philosophy. It’s not glamorous, and even dull for those who like the emotional roller-coaster that comes with individual stock picking.
In a nutshell, MPT confirms that the market price of a security is the right price. It contends that the markets are “efficient” and that all the buying and selling of a stock eventually causes it to find its true value as defined by market forces. Efforts to second-guess the markets are unlikely to produce gains for investors after they have covered trading and other costs such as market timing that are associated with active investing.
Harry Markowitz, the Nobel Prize-winning father of MPT, sums up the case for diversification: “Clairvoyant analysts have no need for diversification.”
A Toss of the Coin
Swedroe describes a coin-flipping contest to make his point about the miniscule chances of even the hottest money managers being right over the long term when choosing stocks. Imagine 10,000 people gathered to watch a coin toss. Science says that 5,000 will guess right on the first toss and 5,000 will be wrong. They sit down. After nine more coin tosses, statistics say there would be 10 “gurus” still standing (although in fact, this number could vary). Swedroe asks, “What probability would you attach to the likelihood that those 10 ‘gurus’ would win the next coin-toss competition?”
This is where the value of having a globally diversified investment portfolio can reduce risk while increasing the chances of positive returns over the long run. (It’s a key activity in a list assembled to create a disciplined, unemotional approach to investing.) It stays clear of taking on the risk that comes with betting on the outcome of events influenced by luck versus skill (as with the coin flippers who may be right – for a time – and then wrong).
Asset Classes Don’t Move in Lockstep
Diversifying between stocks and bonds in an investment portfolio is widely accepted as a proven way to help manage risk. As the values of stocks and bonds don’t usually move in lockstep, the value of one asset class may increase while the other falls. It’s the same when investing in different countries and other asset classes: chances are they will not rise and fall together but will change with the markets. If you are diversified across a range of asset classes, science confirms you will fare better in the long term than if you put all your money into just one or two asset classes or geographical regons.
Despite ongoing market challenges worldwide, the potential for greater long-term returns in foreign markets clearly exists. For example, the Morgan Stanley World Index (the MSCI World) is a market value index covering approximately 45 countries. Over the long term, the price appreciation of this index has been substantial. And among 45 developed- and emerging-country stock markets tracked by MSCI, all but five had double-digit total returns (in U.S. dollar terms), and 25 had returns of 30% or more during the first half of 2011. By comparison, the MSCI Canada Index (which is denominated in U.S. dollars), returned 4.9% over the same period. (I should mention that over the long term, a higher allocation to international stocks can lower the volatility of an all-domestic portfolio. However, the opposite can occur in the shorter term. Foreign markets, and especially emerging markets, can be quite volatile.)
Patience really is a virtue, especially when investing for the long term. Swedroe writes, “Diversification is always working; sometimes you’ll like the results and sometimes you won’t. Diversification in the same asset class reduces risk without reducing expected returns. However, once you diversify beyond popular indices (such as the S&P 500) you will be faced with periods when a popular benchmark index outperforms your portfolio.”
This is when you need to tune out the noise of the media (and other sources) to remain resolved to stick to your plan. It can be tempting to roll the dice on that one stock a relative (whose opinion you respect) was talking up over a holiday barbecue. (I would like to write sometime about the many reasons some investors choose a stock or fund. I have heard everything from, “I grew up with the CEO” to, “I golf with the VP of Sales” – stay tuned.)
And speaking of barbecues, Swedroe writes, “The only free lunch in investing is diversification.”
Work With the Markets
I believe it is indeed best to work with the markets, as opposed to against them. In addition to diversifying your investments, if you structure your portfolio around risks that are related to return; keep portfolio costs and taxes low; don’t chase performance; and rebalance your investment portfolio annually along with reflecting your changing personal needs, you will have a much better chance of controlling your financial destiny.
In future issues of Aggregates & Roadbuilding, I will examine other important topics to help you make the most of your years of hard work, creating wealth and then ultimately distributing it.
* If you would like a copy of Larry’s book, please send me an e-mail.
Jim Sanderson is a wealth advisor with 25 years of experience in the investment services industry. The Jim Sanderson Group at ScotiaMcLeod specializes in helping successful individuals and companies in the aggregate and road-building industries across Canada create and distribute wealth. www.jimsandersongroup.com or e-mail: email@example.com
Print this page