Diversification revisited - overview

It was almost three years ago that I set out my views on diversification and concluded that diversification is mostly a good thing. I did highlight some problems with diversification, the most significant being the fact that diversification protects you from many risks, including the risk of becoming wealthy (to paraphrase Max Gunther). In effect, the more you diversify, the smaller the chances of a spectacularly successful investment having a meaningful effect on your wealth.

Since publishing that post, four things have happened which are relevant to my views on diversification:

1. our household net worth has increased significantly: in effect we now have more to lose. Diversification may be an impediment to wealth creation but is also provides a degree of protection against wealth destruction. Although the degree of correlation between asset classes during the current financial crisis was much higher than many people either anticipated or desired, diversification did provide a degree of protection from the declines in asset values experienced from mid-2007 to late 2008. In particular, gold and government bonds provided good diversification benefits during this period;

2. we have experienced a financial and economic crisis: we lost money. We lost a lot of money. Our two main asset classes (Hong Kong real estate and emerging market equities) were both hit hard during the crisis. We were not diversified enough and suffered greater losses than we would have suffered had we been more extensively diversified;

3. we experienced a significant rally in equity prices and Hong Kong property prices: we invested heavily in emerging market equities beginning in October 2008. Since we sold very few of our investments during the crisis, this effectively amounted a doubling down on this asset class. Those investments have performed extremely well since then (outperforming most other asset classes over that period). This is a clear case of benefiting from not diversifying;

4. the timetable to my retirement has (roughly) halved: put differently, a combination of high income, a good savings rate and very modest returns on investment will more or less get me to my "number" by the end of 2011 or 2012. This means that making high returns on my investments will not make a meaningful difference to my target retirement date but taking losses would have an adverse impact on my target retirement date.

To sum up, my views on the pros and cons of diversification have not changed. I believe that diversification is an effective way to reduce risk but excessive diversification is an impediment to wealth creation. Another way of looking at diversification is to say that you should have less diversification when you are attempting to build wealth (particularly if you want to do so quickly) provided that you have the time and expertise to research, manage and monitor your investments (and a few other things as well) but more diversification when you reach the stage were preservation of wealth starts to take priority over wealth creation.

What may have changed is the application of diversification to my personal circumstances. This raises some further questions which I will address in future posts:

1. what steps should I take to minimise the risks associated with using limited diversification?

2. how should my invest my assets when I wish to place more emphasis on wealth preservation than wealth creation?

3. how much diversification is right for me? What is the right balance between the protective benefits of more diversification and the wealth enhancing possibilities of less diversification and how should I invest my money to achieve that balance.