The Parable of Diversification

He that resteth upon gains certain shall hardly grow to great riches; and he that puts all upon adventure, doth oftentimes break and come to poverty: it is good therefore to guard adventures with certainties that may uphold losses. -Sir Francis Bacon

Diversification is a portfolio management strategy designed to hedge against risk by investing in different asset classes such as stocks, bonds, mutual funds, real estate and precious metals, which are negatively correlated i.e unlikely to move in the same direction. Because different classes of assets move up and down in value at different times, the goal of diversification is to reduce exposure to risk in any one asset class which allows for less volatility and more consistent performance under different economic conditions.
Systematic risk, the risk inherent in the market due to factors we can’t control can never be diversified. On the other hand, diversification eliminates the other kind of risk, unsystematic risk-the risk specific to an individual stock.
Granted that spreading your eggs limits both the upside and the downside potential; a diversified portfolio will however ensure a sustainable long term growth strategy and benefit investors over the long run over holding individual stocks.

It is not just enough to diversify; an investor must ensure that their portfolios are optimized by picking securities that have the highest projected rate of return for their given level of risk. This philosophy is derived from the modern portfolio theory that is widely in use today by money managers.

The parable of diversification.

In early 1975, a man called jack wins $200,000 in a lottery. He decides to invest his windfall conservatively because 1973 and 1974 were terrible bear markets, he opts for purchasing long term government bonds.

In 1979, interest rates skyrocket, and the value of his bonds plunges to $144,000. Well, he decides, I’m going to get out of the bond market and cut my losses. But what to do now? He remembers that gold was selling for $35 an ounce in 1972; today It’s almost at $800 an ounce. Moreover, he just heard someone on the radio predict that it will soar to $2,000 an ounce so he decides to buy 180 oz of gold with his $144,000.

Now the year is 1982, and gold has fallen to $300 an ounce. Jack sells his gold and has only $54,000 left of his lottery winnings, but this time he’s going to be smart. In the early 1980’s, he knows, the only investments that have performed well are oil & gas and real estate. As jack sees it, only one investment makes sense. He decides to buy a condo in Houston. He locates a $200,000 condo and puts $54,000 down and takes out a mortgage of 146,000.

The years pass and it’s 1987. He’s paid his mortgage down to $110,000 but Houston’s real estate prices have crashed and his condo is only worth $120,000. jack decides to cut his losses. He sells the condo for 120,000, pays off his $110,000 mortgage and moves out of Houston with his remaining $10,000.

It’s now 1995 and jack is living in Silicon Valley. Everyday, he hears stories of this thing called the internet. He decides to invest his remaining $10,000 in a mutual fund, the extremely aggressive all internet fund.

By early 2000, we find jack thinking early retirement-his mutual fund is up 50% just in the past month! Given very strong returns, his fund is now worth $80,000!! But then the dot com bubble bursts and his fund looses over 95% of its value in the next two years. Jack has just $4,000 left. But he keeps telling himself: all I need is one good investment”

The moral of jack’s story: diversify, diversify, diversify!

This is what would have happened if jack had diversified his winnings. If jack had invested in :

25% real estate
25% Gold*
25% small cap stock
25% long term bonds

For the period from 1975 to 2000, his portfolio would have been worth $3,245,524

*Gold index inception: May ,1985