John owns a business that sells umbrellas and galoshes. Jane’s business sells sunscreen and bathing suits. Both of these business owners are profitable, over all; but they both experience broad fluctuations in their business revenues, depending on the weather. One day they decide to merge their businesses. Now their income is more steady. This is called diversification. John and Jane now have a more robust business than they would have had separately, because a major factor – weather – has a much smaller effect than previously.
John and Jane are glad that they diversified. You should also diversify your investment portfolio, and for the same reason. Almost all investors are happier when their portfolios grow more steadily.
Let’s talk some more about John and Jane. The following things are true for them, and for you:
- They are well diversified with respect to weather, but there are more steps that they can take: they can diversity geographically, by opening stores in new cities; by market size, by offering more different products in various price ranges; by distribution channel, by operating a web site or a toll-free phone number; and in many other ways. And they probably should, if they want their business to grow.
- Diversity does not guarantee profitability. If they merge two mediocre businesses, they will just get a bigger mediocre business. Diversification is more of a risk management strategy than a profit maximization strategy. They may not be the most successful business around, but at least they can put food on the table whether it’s rainy or sunny! So they can sleep better while they explore ways to improve their business.
- Poorly chosen diversification is worse than none. Suppose the next branch store they decide to open is located in Saudi Arabia. It doesn’t rain much there, and very few people wear bathing suits, for religious reasons. Do you think this will improve their business results, or reduce their risk? I don’t.
- Business cycles still happen, and still affect their results. Long term weather patterns, government regulations, tax policies, consumer sentiment, and many other things will still happen. Sensible diversification does not eliminate all risks; it just tempers the effect of certain ones that you can do something about.
It’s not terrible to have business results (or investment results) that vary from month to month or year to year, especially if you have a long time horizon. If you are not going to need the money for 30 years, who cares what wild gyrations happen in the meantime, as long as the end result is good?
If you really, in your heart of hearts, agree with the above paragraph, then you have what is known as a “high risk tolerance.” You are psychologically capable of ignoring short term cycles and fluctuations while keeping your focus only on long term results. For you, the main job is to identify long-term profit opportunities.
Most of the rest of us need to be honest with ourselves: we don’t have the stomach for large changes in our portfolios[i]. When we open our statements and see that our balance has dropped 25% in the last month, we freak out, and lose sleep worrying about whether the market will ever recover! Next thing you know, we’ve panicked, and sold everything. Repeat this behavior over the years, and we’re eating cat food during our retirement years.
Everyone has a different risk tolerance. It’s critically important to know yours. Once you have, use intelligent diversification to design a portfolio that mitigates the risks that are out there. You, John, and Jane will all sleep better for it.
[i] When I say “large changes,” I really mean “large drops.” Most investors would be ecstatic at a 25% increase in their portfolio value in a month. If you can figure out how to have upside volatility without a corresponding downside, please let me know!
Fighting Financial Fear 