Diversification! What Does That Mean?

When you invest, whether it is in mutual funds, ETFs, or stocks, you learn about diversification. It’s a “good thing” they tell you. But what exactly does this word mean? Wikipedia defines diversification as “reducing risk by investing in a variety of assets.”

Words change over time. For example, the little three-letter word “let” once meant “hinder” After a long enough time it turned into its opposite “go ahead”. I’d suggest that “diversification” too has changed into something completely opposite to what it meant in the past.

There’s a reason for that. Beneath the word, “diversification,” there are many new kinds of risk at work. Let’s look at just three of these risks.

Concentration risk

This risk applies to the dangers of putting all your eggs in one basket. Unfortunately, things in the markets have gotten so complicated, you may not realize you’re putting your eggs in one basket when you invest. This is particularly true of investing in ETFs.

A recent Wall Street Journal article, “Look Inside Country ETFs” talks about concentration risk in country ETFs. It warns that individual country ETFS are not as diversified as you’d think. The ETF basket for a country may be dominated by one large company in that country. What happens to that company can heavily influence what happens to the value of your country ETF.

Rob Curran’s article quotes an investment advisor who says the antidote to concentration risk in country ETFs is to invest in regional ETFs rather than in individual country ETFs. Supposedly regions of the world are safer than countries. The bigger the better? Do you believe this? Diversification now equals “too big to fail?”

After years of being told by your advisers that diversification meant investing in smaller segments of the markets that would offset each other, can you now switch gears and trust advice to invest in bigger segments of the markets? Read on…

Systemic risk

Wikipedia defines systemic risk as “the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system.”

Systemic risk is what happened when the financial crises began. One bank failed and many more followed. They’re still following. This year bank failures are on track to exceed even last year’s total.

Lehman Brothers, one of the first banks to fail, was using a device called Repo 105 to remove debts from its balance sheet. Lehman’s own board wasn’t informed of this accounting trick. So how could stockholders have known? How could holders of mutual funds or ETFs that included Lehman’s have known?

So, one challenge you have is deciding where your investments fit into a particular financial system. Then you need to figure out what’s going on in that system. This is why many are calling for more “transparency”in investing as well as a crackdown on fraud in investing. But is this enough?

For a long time, industry sectors were seen as a way to diversify a portfolio. Unfortunately, systemic risk seems to have leveled the playing field among sectors. What happened to our financial industry sector soon impacted every other industry sector of our economy. And it still is affecting nearly every sector of our economy and indeed much of the world economy.

Market risk (equity risk)

This is another risk that can affect what you think of as a diversified portfolio. Got mutual funds or stocks in different kinds of companies, e.g. “large cap” small cap” mid-cap,” “value” or “growth”? Well, what if the entire stock market falls? Flash crash anyone?

Once upon a time, investors were advised to invest in the five main segments of the U.S. stock market as a way to diversify. Now “diversification” seems to mean the opposite thing. Advisers tell you to invest in the entire stock market by purchasing some kind of fund that is based on a total or a broad market index.

Or, as we saw above under “Concentration risk,” advisers suggest you invest in an entire region like Asia or Europe rather than in a country within that region. Somehow this is supposed to be safer than sticking with particular market sectors or company groupings, or sticking with individual countries in different parts of the world.

Do you believe that? What about “systemic risk, especially the systemic risk of “sovereign debt” default or bankruptcy of an entire country, especially a country that is part of a bigger system such as the European Union.

Why can’t a bigger chunk of a system fail as rapidly as a smaller chunk of a system? And these days, with all the interrelationships in global business, why can’t a bigger chunk fail even faster and further than a smaller chunk?

Back to fundamentals?

Is it any wonder we have no idea of which way to go right now? Basically, lacking any good gauge of markets, it looks like we’re back to the “fundamentals” of investing in companies.

These days, a smart company, such as Apple, can put paid to the entire rest of a failing sector (i.e., tech stocks). These days, traditional groupings of companies into market segments are not holding up. There are reasons for this. Companies each operate in different ways.

For example, a WSJ article “Divided by Two-Track Economy: As Foreign Demand Buoys Some U.S. Companies, Others Struggle to Attract Consumers at Home” features a chart showing which “large cap” companies are doing well and which aren’t. The article says success or failure of a company is due to where individual companies market and sell their products. Those companies who sell abroad are doing better than those who sell at home.

No matter what markets you invest in, It all comes back to digging into the doings of individual companies (or in the case of government bonds, digging into the goings on at individual government entities, such as cities, states, and sovereign nations).

For this reason, I still recommend highly a book I read before the crash. That book is Rule #1 The Simple Strategy for Successful Investing in Only 15 Minutes a Week by Phil Town (Crown Business, 2006) It’s a good place to start while we all wait for Penn State Professor John Liechty and his colleagues to make sense of the risks of the market these days.

Copyright © 2010 Nancy K. Humphreys