Diversification & Risk Management: Lessons from History for Investing

Introduction

In the mid-19th century, Ireland faced a devastating famine triggered by the over-reliance on potatoes as a staple food. The potato crops were decimated by a disease, emphasizing the vulnerability of depending on a single source. Fast forward to today, and the same principles apply, not in agriculture but in investing. Ecclesiastes wisely advises, "Divide your portion among seven or even eight, for you know not what disaster may happen on the earth." [Ecclesiastes 11:2]

The Importance of Diversification

Have you ever heard someone claim they lost all their money in the stock market? This unfortunate scenario usually arises when individuals invest heavily in a few companies, and those companies face financial hardships or go bankrupt. Diversification in investing is akin to heeding Ecclesiastes' advice, spreading your investments across different assets to protect against the unforeseen.

An example that resonates with recent times is WeWork, a once highly valued startup that filed for Chapter 11 bankruptcy in 2023 due to the impact of the 2020 pandemic. Diversification involves managing three types of risks: systematic (market risk), unsystematic (company risk), and catastrophic risk.

1. Systematic or Market Risk

Systematic risk pertains to broader market forces impacting the entire investment landscape. Factors such as interest rate changes or macro-economic data can trigger market-wide movements. Modern Portfolio Theory (MPT) suggests diversifying across different asset classes—real estate, gold, bonds, and stocks—to reduce overall portfolio volatility. However, this approach may also lead to reduced returns.

Warren Buffet, Charlie Munger, and Peter Lynch, some of the most successful investors, prefer a different approach. They focus on buying wonderful businesses at fair prices, emphasizing the potential for companies to generate increasing profits over time. A comparison of a diversified MPT portfolio and the S&P 500 from 1995 to December 2023 shows that, while MPT may reduce drawdowns, it could result in $1.4M less than investing in the stock market alone. [Source: Investopedia]

2. Unsystematic or Company Risk

Unsystematic risk is specific to individual investments and includes factors like bankruptcies or sudden market changes affecting a particular company. WeWork's downfall serves as an example. A diversified portfolio spread across various industries helps mitigate the impact of challenges faced by any single company. Regular portfolio management enables the identification and addressing of declining financial health before severe consequences occur. [Source: Investopedia]

This is similar to having multiple baskets for your eggs. While the fate of every single holding is unpredictable, a diversified approach minimizes the impact of any single company's troubles on the entire portfolio.

3. Catastrophic Risk

Catastrophic risk involves unprecedented events like global conflicts, currency devaluation, or natural disasters. These events go beyond normal financial strategies, and no investment—be it gold, bonds, or stocks—can fully shield against them. Acknowledging this reality is crucial when crafting an investment strategy.

Preparing for the unimaginable is like bracing for a world war, a collapse of the financial system, or even an asteroid hitting Earth. In such extreme scenarios, financial instruments offer limited protection. [Source: Investopedia]

Conclusion

In conclusion, diversification is not just a financial strategy; it's a prudent approach to navigating the uncertainties of the investment landscape. By learning from historical lessons and embracing diversification, investors can better manage risks and enhance the resilience of their portfolios against unforeseen challenges. Ecclesiastes' timeless wisdom reminds us that spreading our investments across various assets is a safeguard against the unpredictable nature of the financial world, ensuring a more secure and balanced financial future.