Try Not to Concentrate - Show 133

Thursday, August 14, 2014 4,572 views

Don’t put all your eggs in one basket. This common sense advice is essentially a warning to diversify, or else you may watch all your eggs…or savings…break. A diversified portfolio which captures the right blend of market indexes reaps the benefit of carrying the systematic risk of the entire market while minimizing exposure to the unsystematic and concentrated risk associated with individual stocks and bonds, countries, industries, or sectors. To put it another way, what is the opposite of concentration? Dilution. If someone places a few drops of pollutant in a small bowl, the entire bowl will be polluted. Put those same few drops in a giant swimming pool and the pollutant will disperse over a greater volume, diluting the negative effects. It’s one reason a home aquarium is so delicate and can crash in a moment, while the ocean has no problem handling the natural pollutants caused by the fish. So without unsystematic risk and concentration risks, a diversified index portfolio leaves you only with the risk of the market itself. And if you want returns, it’s a risk you have to take.

As capitalism has expanded throughout the globe, it has become more and more important to invest a large chunk of your portfolio in international stocks. Back in the 70's, the U.S. comprised more than 68% of global equity value. Fast forward to today…it now comprises less than 50%. Investors achieve a sizable benefit by increasing diversification and capturing the expected returns of global capitalism by investing in index funds comprised of international developed countries and emerging markets countries.

But diversification doesn’t stop with spreading your wealth around the world. As Dr. Emmett Brown told Marty McFly, “You’re not thinking fourth dimensionally!” Marty wasn’t thinking about time. It is important investors diversify across time. When investors maintain a globally diversified portfolio for long periods of time, they are able to maximize their ability to capture the complete range of returns that are offered by the global markets. Jumping in and out of the market at different times is simply choosing to invest at certain times as opposed to putting all your eggs in one basket by investing certain companies. But the problem created is essentially the same. You have to guess right…a lot. At IFA, we pride ourselves in our ability to think fourth dimensionally. And we help our clients understand why it’s important to diversify across asset classes and across time.

 

 

 

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