Tag: stock market tips

Diversification with respect to asset prices

Diversification is often thought of, in terms of asset classes and age groups. You will normally hear that the weight of equities in your portfolios should decline, as your age increases.

So while it is fine for a thirty year old to have 70% equities, a 50 year old is much better off with only 30% equities.

So if you are thirty years old, should 70% of your portfolio be invested in stocks, regardless of stocks being at all time highs or lows?

Asset Prices and Diversification

I have never heard of diversification with respect to asset prices. The point is that asset prices move in cycles and you should diversify keeping the current cycle in mind.

About a few months back, stocks were trading at all time highs, and a lot of people made a lot of money. At that time it would have been prudent to reduce exposure to equities and move into safer instruments like money market funds. That would have been true, regardless of age or the other asset classes in your portfolio.

The fact that you are just 25 years old doesn’t protect you from sliding stock prices. It helps you because you can wait a longer period for stock prices to recover. But it doesn’t protect you from the slide that happens at that point in time.

The fact that stocks are at 11 year lows today; make them cheaper than other assets. This should be the time to increase your exposure to stocks because stock prices are lower and the value of “money” is higher.

If  you view money as an asset class (which most people don’t) you’d realize that today you can buy more stock per dollar than any other time in the last 11 years. That makes money expensive and stocks cheap.

Which indicates that you should move out of money and move into stocks.

Assumptions

I know that the key assumption that I make here is with respect to stock earnings. The assumption is that in the long run; the earnings will continue to rise. In the next few quarters the earnings may go down, but in the next 11 years they will rise steadily.

If you disagree with this assumption and see a deep recession or depression coming, then you are better off without stocks. The other reason to stay away from stocks would be, if you thought something else could make you more money; like gold. Else, investing in stocks at this time may not be a bad idea at all.

How do you think about diversification? Do you think in terms of asset prices or in terms of asset classes and age groups?

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Diversification will reduce your profits

Diversification is the mantra for reducing exposure to risk in the markets. What this also means is that the potential to make sizable profits in the markets go down.

Don’t get me wrong, I am all for diversification. But, when diversifying, you should understand the fact that by putting your eggs in different baskets, you are reducing the chance of any one of them making your basket grow much bigger than it currently is.

Most people do not treat their stocks as companies that they own, and therefore are not able to think through “diversification” properly.

Let me give you an example of thinking through diversification. When I was going through annual reports of companies that produce capital goods, a common risk I noticed was rising input prices.

All these companies said that they had very little control over raw material prices and any rise in them will impact profitability.

So, the next thing was to find out what raw material they were talking about?

No surprises here, all the companies were using steel as one of the primary inputs and a rise in steel prices posed a big threat to their profitability.

Now if you have three stocks in your portfolio that use steel and the rising price of steel is posing a threat to their profitability, you should probably go out and buy yourself some good steel stock. That one purchase diversifies three stocks that you have.

If you think about stocks as businessses that you own, it becomes easy to diversify. After buying the steel stock, I realized that most of the portfolio was favoring capital goods and machinery and I did not have a lot of stocks that will benefit from retail buying.

So I went out and bought a fast growing retail chain store of India. That had me diversified across sectors. Doing this exercise a few times over helps you get a good perspective on your portfolio and how diversified you are.

The important thing is to think of your stocks as businesses and think about how they make their money. Once you think in that direction, it is easy to see which other businesses will profit, if this one was going down. Then go ahead and buy some stock of the leader in that business.

Researchers have come to the conclusion that if you select around 20 stocks carefully, you are diversified enough. Any more stocks after that number do not protect you from losses to a greater degree.

So, the bottom line is to think like a business owner and not over-diversify.

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