Financial Diversification

The following is a guest post from Rudy from Smart Money Today. You can follow Rudy on Twitter @SmartMoney00.

Hi, my name is Rudy and my blog is Smart Money Today.

Sabeel and I have a similar†story; we had a hard time during the 2008 financial crisis, and we got screw from the so-called “financial experts” by paying too many fees. We realized is better invest in our financial education first and take the matter into our own hands to avoid paying “silly” fees and get better ROI (Return On Investment). But this isn’t what the article is about.

This article is about how you can use diversification to reduce your risks associated with investing. As a result, you can preserve your wealth but still be able to take advantage of the market stock high returns.

NOTE;†One thing you should know: I was born and raised in Italy, so English isn’t my native language. This is the reason why my English sometimes might sound “funny”, but I had the deep desire to help others to achieve more with their finances and English is the best language to spread my knowledge in the world.

I’m constantly working on my portfolio diversification to improve the bottom line; over the years, I went from a single digit growth to a double-digit not by taking extra risks but by diversifying my portfolio strategically.

I was reading Sabeel’s blog and found interesting his way to diversify†investments geographically, you can read his recent post; Geographical Revenue Diversification of My Holdings.

What is Diversification? Diversification†is the process†of allocating capital in a way with the goal to reduce risks.†

Well hereís the truth: investing is†risky.

But without investing you also risk to never retire (ok, if you have a paying job as CEO making more than US$ 200,000 per year and living a frugal lifestyle, you don’t need much of an investment strategy).

Did you ever heard the old say; “Don’t put all your eggs in one basket”. I’m sure you do.

People think they are diversifying when they aren’t. Sound impossible?

Let’s have a look at Mr. Tom investments to get a better grasp of the concept.

NOTE; The portfolio below is for the sake to get a better understanding of†diversification.††Type of†assets and percentage of portfolio†weight are purely casual.†

Mr. Tom thinks to have a “diversify portfolio” (what his financial advisor is saying).

The portfolio is:

• 50% US Long-Term Bond ETF
• 50% S&P 500 Index

The amount invested is US$10,000.

Mt. Tom’s portfolio has a diversification in asset classes in a domestic portfolio. This is a good start for Mr. Tom in the world of investment, but more can be done to reduce his portfolio risks and increase returns drastically.

When investing, first we focus on reducing risks, second on capital gains.

“Rudy, investing isn’t all about making as much as possible?”

Yes and No.

The primary focus for any investor is “Capital Preservation”; Protecting the absolute monetary value of an asset as measured in nominal currency.

Keep savings in a bank account just because its perceived safe, isn’t going to preserve your capital.

Inflation reduces the purchasing power of currency over the years. This means, if today I can buy a burger with US$ 1, in ten years time the same burger will cost US$ 1.50, so my purchasing power has been eroded 50% during a period of 10 years.

During these 10 years, if my capital grows 50%, I achieved the goal to preserve my capital.

What about preserving your capital from the risks of investing?

In our example with Mr. Tom, he diversifies in two different asset†classes; bonds and stocks.

During the 2008 financial crisis†(December 2007 and ended in June 2009) both classes did poorly, however bonds hold up better than stocks.

Tom’s portfolio†during the 18 months recession lost 21.1% in value. Tom’s was left with US$ 7,890 after the recession.

December 2007 to June 2009

BOND

STOCK

It’s clear that a†simple diversification with bonds and stocks have reduced the losses of a 100% stock’s portfolio. In the other hand, a portfolio holding only bonds would have been the least painful way to go with a loss of 9.2%.††

The above charts represent the 18 months recession,†but below I show you an entirely different scenario taking in consideration a shorter period at the heart of the recession from August 2008 until February 2009.

These 7 months saw the collapse of†Lehman Brothers, the fourth-largest investment bank in the USA, an aggressive FED with a QE program and houses for sale all around the USA.

Tom’s portfolio saw the worst during this shorter period; US$ 7,600.

†

August 2008 to February 2009

BOND

STOCK

Tom’s portfolio in the shorter time during the roughest months of the recession lost 24% of its value. Tom with a 100% bond holding wouldn’t have noticed anything during these 7 months, but if fully invested in stocks, with a 48% drop he might had a heart attack.

I conclude that a domestic portfolio with a simple diversification like bonds and stocks can:

• reduce the portfolio risks
• smooth out the ride of the market stock
• help to weather any financial shocks

I have a problem with this type of “diversification”. The long-term bonds and stocks don’t do a good job to protect the capital.

During periods of financial stress, these two classes tend to follow each other. Let me clear, only medium and long-term bonds, short-term bonds usually keep moving up even during of financial distress.

The next natural question is: “There is a better way to diversify a domestic portfolio?”

My answer is; “Yes”.

Asset Classes Diversification For A Domestic Portfolio

I’m talking about†domestic portfolio because later I will show you how to reduce further risks with an international portfolio. I know it’s a long post, but please bare with me a bit longer.

Mr. Tom got stressed out from his financial loss during 2008 (Sabeel and me too), so his mission was to find out a better way to reduce his risks by expanding asset classes.

He came up with a new portfolio:

• 25% US Long-Term Bond ETF
• 25% S&P 500 Index
• 25% Cash
• 25% iShares Gold Trust

This is a “Permanent Portfolio” introduce by investment analyst Harry Browne in 1980.†Browne stated that a portfolio equally split between stocks, precious metals, government bonds and cash would be a safe and profitable portfolio in any economic climate. History has proved his point, this portfolio has only 4 years losses over a 30 years period.

The 4 asset classes related to a particular†economic condition:

• growth stocks would prosper in expansionary markets
• precious metals in inflationary markets
• bonds in recessions
• cash in depressions

There is a fund that follows this principle called†Permanent Portfolio Permanent N (PRPFX). When looking at the graph, don’t dismiss the permanent portfolio because in the last three years didn’t perform so well compare to the market stock. This portfolio during periods of expansion underperform the market stock but outperforms in the time of financial distress.

At the moment, we are at the end of an unprecedented expansionist cycle of the market stock which has rewarded investors heavily invested in shares and long-term bond holders. Keep in mind that nothing last forever.

A†reversal of cycle is unavoidable†and will bring chaos-disappointments for investors which†aren’t prepared to change strategy swiftly.

During accumulation†and markup phase cycles, long-term bonds+stocks offer “sweet” returns, but once the fall-down phase shows its face, the pain is unbearable. Some might argue that the market stock will recover and it always goes up, but I think there is a better way to minimize the downside and maximize earnings.

If you read my article about economic cycles (they exists, aren’t just a myth) then you can plan your investment strategy accordingly. It’s clear we are in a “Distribution Phase cycle” and the next “Fall-down Phase” is coming.

I now what you are thinking, you want to know when will be due the next cycle?

No one knows, but I assure you in the next months/years the market stock isn’t going anywhere as an index. Of course, some good company within the index will always outperform even in a downturn, my hint is to look into “Consumer Staples” stocks.

Sabeel might give us a better inside about this wonderful industry, he is far more knowledgeable than me in stock picking.

Let’s move on and have a look at the performance of gold and cash during the last recession.

December 2007 to June 2009

GOLD

August 2008 to February 2009

GOLD

Gold is a winner class during distress times, however, is a poor performer as an investment on its own. In 100 years, the gold return is a mere 300% against a whopping 1300% on the Dow Jones.

The reason is simple; the only thing gold does is to be “shiny and sit there”, the Dow Jones hold the best of corporate America which produce growth and profits.

Cash during the last recession is been queen, losing nothing in both scenarios.

Let’s have a look how†Tom’s portfolio would have performed with the 2 new classes; cash and gold.

December 2007 to June 2009

• 25% US Long-Term Bond ETF = US$ 2,270
• 25% S&P 500 Index†= US$†1,675
• 25% Cash†= US$†2,500
• 25% iShares Gold Trust†= US$ 2,787

Tom’s is left with US$ 9,195.

†

August 2008 to February 2009

• 25% US Long-Term Bond ETF = US$ 2,500
• 25% S&P 500 Index†= US$†1,300
• 25% Cash†= US$†2,500
• 25% iShares Gold Trust†= US$ 2,750

Tom’s is left with US$ 9,050.

By adding gold and cash to the mix, Tom would have drastically reduced his losses.

Gold usually move in opposite direction of long-term bonds and stocks, definitely a good buffer during times of financial distress.

Cash also does well during a†recession because hold its value, but get bite by the inflation over an extended period.

A good alternative to cash is to buy a short-term bond or T-bills, which has a constant uptrend during good and bad times.†Bonds are a defensive strategy to grow your wealth,†I believe any portfolio can benefit by owning some bonds.

However this year with the increase in interest rate by the FED,†bond owners should be careful and not overexpose to medium and long term bonds.

Gold Is The King Of Diversification

NOTE; In my portfolio, I donít hold gold ETFs. Instead, I hold physical gold.†

I live most of the year in Asia, where gold bars are easily accessible and can be traded like cash. The spread between buy and sell prices is a mere 0.5%.

In Europe buying gold is more complicated, there are few companies which bring the gold to your home or store it for you (you need to store gold yourself to be sure to have it, no point having a†piece of paper), but I think you canít sell it back easily. Regarding the USA, Iíve no idea.

Buying physical gold, shield me from cataclysmic events such a total collapse of FIAT CURRENCIES or†the meltdown of the financial system as known today. I might sound like Nostradamus, but mine aren’t predictions. Instead, I’m open minded to a variety of risks and possibilities.

Again, gold is a diversification in the diversification, offering a hedge on the stock downturn cycle and moving away from paper assets.

Buy only physical gold if you can, remember ETFs are†redeemable for cash, at no time do you own a gold coin or bullion bar.

There is more; You are entrusting your wealth to the mega-banks that serve as the primary custodian for the ETFís bullion.

Arenít the same financial institutions which cause the 2008†crisis and got a bailout from the American†taxpayer†and in the process throw thousand of Americans in the street?

Let me ask you something; ìDo you believe so much in the financial system, the central banks and governments to entrust your life savings?î Let me know your thoughts in the comment below.†

My comment is sharp and to the point; I would feel more comfortable to entrust my wallet to a drunk hooker than the above organizations.†

Diversification For An International Portfolio

Moving away from a domestic portfolio†come with rewards and drawback.

Let’s have a look why investing abroad is a good idea:

• Diversification of currencies. If you are an American and own stocks in Europe, you will have double gain/loss in the stock market and from the currency.
• If one country is doing bad, another†could do well. Mixing up your investments between different economics will smooth out your investments.

There is some bad too:

• Abroad some product or broker might not cover you in the†case of default.
• Costs. Operating abroad has higher costs such transfers, exchange rates and other commissions.

In the last century, diversify between countries was the real kicker†to shelter from uneven world growth.

In recent years, the world markets are more interconnected than ever, they tend to move in tandem. However, different monetary policy and war currencies between central banks are offering great opportunities for the savvy investors.

Hereís a real-life example of how investing overseas can improve your returns.

I got specialized in investing in the Thai market stock using my deposits in US Dollars. This started back in June 2013 when the FED hint an end to the stimulus, while the Thai Baht reached is strongest position against the US dollars for the previous 15 years and the Thai export was suffering.

I little know by then that this situation would have offered great opportunities till today to make massive gains from currencies and Thai market stock moving in the same direction.

The Thai market is small and very sensitive to foreign investments. Whenever foreign investors pull in money, the Baht strengthen alongside with the stock market.

In a†reversal, the opposite happen; The market stock goes down, and the Thai baht weaken. Still today isn’t clear to me all the forces in place, but†I just follow the trend and make money along the way.

Whenever I notice the Thai baht strengthening and the market follows, I start to buy Thai shares with a strong US dollar position. I hold for few months riding the uptrend and once the market goes flat, I sell for profit taking.

I benefit from the stock market gains as well as by selling the stronger Baht for a weaker US dollar.

DOUBLE KILL!

Sometimes I’ve got the feeling to play a video game.

I’m not an expert currency trader, but I can see trends over time.

NOTE; As I make double gains, I’m well aware I can make a double loss.†

DOUBLE NOTE; If you are new to investments, take a simple approach. Avoid to play my game, you need mental preparation and a sound knowledge of market movements.

Some Talk About Currencies

Just a hint from me. The US Dollar is entering in an overvaluing territory, without rush in the next two years is sensitive to move money away to†undervalue currencies like Japanese Yen and Euro.

Money markets†are well profitable, especially in the last 7 years where the flow of money is predictable thanks to the central bank’s policies.

Europe is still pushing for QE and China is playing down the Yen, plenty of opportunity in the sea.

I’m Italian, so my currency base is Euro. For an American would be the Us Dollar.

The Euro has lost 45% of its value against the US Dollar in 8 years.

It’s clear the benefit of diversification in foreign currencies. The weakening of Euro is nothing scientific or shocking.

Slow economy = Weak currency

Healthy economy = Strong currency

Europe economy never got out from the 2008 recession, so the Euro currency is the ultimate victim. Instead, the USA has been able to create jobs and increase GDP by an average of 2% per year, so the American dollar is benefiting.

One question for you; “Do you think there are higher chances of a stronger Euro or a stronger US Dollar in the next 10 years?”†Please,†comment below.†

Enough about currencies, let’s test out an International passive portfolio to learn if we could have reduced even further risks for Tom and his brother.

Tom’s brother is half American and half Chinese (the mother married two times). His name is Kim.

Kim’s portfolio is geared forward American and Chinese equities, with some gold and cash just to weather the rough times.

Kim’s invested $US 10,000, holding:

December 2007 to June 2009

• 25% US Long-Term Bond ETF = US$ 2,270
• 12.5% S&P 500 Index†= US$†837
• 12.5% China Large-Cap ETF = US$†825
• 25% Cash†= US$†2,500
• 25% iShares Gold Trust†= US$ 2,787

Kim is left with US$ 9,219.

As said earlier, today countries have similar trends. China is a producer focus on export instead the USA is a service oriented economy, however during the last recession the Chinese and US index had a†similar drop.

August 2008 to February 2009

• 25% US Long-Term Bond ETF = US$ 2,500
• 12.5% S&P 500 Index†= US$†650
• 12.5% China Large-Cap ETF = US$†712
• 25% Cash†= US$†2,500
• 25% iShares Gold Trust†= US$ 2,750

Kim is left with US$ 9,112.

By adding the Chinese index to the portfolio diversification, Kim’s got a better return (or should I say a reduce loss). However, in the post-recession the US and the Chinese index had entirely different†returns on investments till today;

Geographical diversification offers an extra layer of protection, it’s an excellent strategy to reduce risks from one economy. The hard part is to pick economies with a strong future prospect, not always so easy.

I always recommend holding corporate America as the majority in a portfolio. For the rest is up to you.

Conclusion

Diversification is a sensible strategy for any investors (even Warren Buffett), but there isn’t a single recipe for success. Every investor needs to find his diversification strategy which work for him and sticks to it during periods of expansion and contraction.

Only the time will reward you for your patiance.