Diversification: The False God

Submitted by Greg Garabedian on Friday, April 13, 2012 - 9:00am
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Diversifying your holdings is supposed to insulate you from market ups and downs. Asset A drops, but Asset B’s rise will offset it. But how many times have you looked at your diversified investments and been disappointed?
 
Have you ever thought: “I did everything the way I was supposed to, I placed my investments into diversified asset classes. Why have I not made money over the past decade?”  This is a conversation that many of us have had with ourselves over the past 10-plus years, better known as the Lost Decade. 
 
Think back to the scene in the film Good Will Hunting, when Sean (Robin Williams) realizes that Will (Matt Damon) blames himself for the abuse he took as a child. Sean repeatedly tells Will “it’s not your fault,” until Will breaks down crying and acknowledges that’s true. From there, Will is able to continue with his life in a healthy fashion. It’s important for everyone abused by the market to realize as well that it’s not your fault.
 
If you have been investing anytime over the last 30 or so years, you have probably used Modern Portfolio Theory. MPT teaches you to spread your investments over different asset classes -- and that this diversification balances out your risk. In theory, it sounds like a good idea and that is what the majority of investment advisors have urged clients to do for a long time. 
 
The theory worked well during the great bull market we saw since the early 1980s, but at other times it did not. Different assets markets became correlated, meaning they moved close together, and didn’t offset each other. They all dropped horribly in the 1987 crash, the 2000 tech bust and the 2008 financial crisis.
 
Sometimes, investors do things because that is the way it has always been done. But MPT is not the way it has always been done.
 
In the past, investors bought investments based on their research, held them for a while and sold, hopefully at a profit. This type of investing takes a lot of work and time. That is why advisors and investors moved to MPT because it didn’t require a lot of thought. 
 
Fortunately, the painful bear market of 2008 woke up many to MPT’s shortcomings. So what should you do? 
 
No matter how intelligent you are, you must realize that, when it comes to investing, you will get emotional and make mistakes. All it takes is a bull market for you to think you are a financial genius. Just remember the old adage: Never confuse brains for a rising market.
 
By the same token, when everyone is getting out of the market, that doesn’t mean you should, too. That is a good time to pick up bargains. In early 2009, when investors were exiting stocks willy-nilly, America was on sale. People who bought then feel very good about that.
 
But buying takes an intelligent eye. Not all bargains are troves of temporarily hidden virtue.
 
It is important to have a disciplined approach to investing -- one built on process rather than on emotion, or on what you saw on a financial channel. If you don’t want to spend a few hours each day managing your investments, find someone who will do it for you, and without emotion.  Someone who has a structured approach that is different than just spreading your investments into different asset classes and riding the market roller coaster. 
 
Remember, it’s not your fault.
 
Greg Garabedian is president of Garabedian Wealth Management Group in Pasadena, Calif.
 
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investments(s) may be appropriate for you, consult your financial advisor prior to investing. Securities offered through LPL Financial. Member FINRA/SIPC.
 
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