Vincent’s Blog: Diversification is only protection against ignorance

The drill is making a loud chirping sound while it makes its way down my right second molar to fix a small cavity. I am looking at my dentist: he has long hair and a youthful expression. I think he is in his late 40’s. He must like traveling because I see artifacts from Asia splattered all over his otherwise modern office.I just met him a few minutes ago as I am in the south of France and need to take care of this immediately since the cavity is giving me some trouble. On the way in I think I saw a diploma on the wall, like you see them in all dentist offices in America. He studied at the Faculté d’Odontologie Aix-Marseille. I guess I can trust him. I mean a second molar is the same in the US, Asia or elsewhere for that matter and so is a cavity, right?

While the molar and cavity might be the same everywhere, industry standards, experience, oversight and legal recourse differ greatly from place to place and are often overlooked by consumers and investors. We are trained to think that diversifying our investments reduces our overall risk. The thinking is borrowed from the insurance business, which aims to spread risk over a large number of entities reducing payout for accidents. It is generally a good idea to spread your risk as an insurance company but let’s see how they deal with risk diversification once Google drives all cars…

Does diversification make sense for an investor and if so what do I need to diversify: Asset class; Investment styles; Geography; Sectors; Market capitalizations; Number of holdings? How much less risk do I get by diversifying? Do you know the answer? Can your bank or advisor quantify your risk and by how much diversification reduces it? Or are they just stating your risk is being somewhat reduced through diversification?

You see, we all have a hard time putting an absolute number on risk diversification and end up doing what the experts are telling us to do or what everybody else does. But what is good for insurance companies might not be the best for investors. What we don’t see or hear often gets neglected. This is true for my molar but also very true for investment processes and strategies.

Warren Buffett advises not to buy more than six different companies if you want to get above average results. Unfortunately, all that is repeated by everyone is his advice to buy an ETF on the S&P index. But did you ask yourself: do I want average returns? What about Geography? Do I have to buy emerging market growth in emerging markets or do I buy companies with exposure to emerging markets? Details matter a lot and the results of a bit more digging and analyzing are often surprising and will help reduce your investment risk greatly.

Did you know the Global Index consists of 60% US domiciled companies? Did you know the US contributes only 25% to Global GDP? Did you know that almost 50% of revenues of all companies in the S&P500 are earned outside the US? Did you know that the S&P500 only allows US domiciled companies in its index? Did you know that SAP, BIDU and InfoSys are US listed companies but domiciled in Germany, China and India? Did you know that return on investment bares the same definition everywhere in the world but that other factors, which are often overlooked, vary significantly from one country to another?

Experienced financial market oversight, one accounting standard, tested back-up trading exchanges and a judicial system with legal recourse are often only mentioned when it is too late. Concentrate and think about your dental work and where you want to have it done. It may help you change your view on investment diversification and risk.