Myths about diversification Part 1

Diversification; be specific

“Diversification” - hands down the most overused term in any industry. Why do people love this term and why is it so universally revered? Anyone that owned a small number of Tesla or Apple shares a few years ago is certainly wishing they did not “diversify” so much. Meanwhile people who owned Exxon or Uber shares are probably happy they own other assets and limited their exposure to those stocks.

There is insufficient guidance around how to apply the concept of "diversification”. When is diversification hurting us and when is it helping us? It is such a broad concept that is rarely helpful in insolation. In the next few articles, we will try to provide clarity and useful tips on how to diversify.

What is the goal of diversification? To reduce losses imposed by any one eventuality. It is achieved by spreading our eggs across many baskets. If one basket falls and the eggs inside it are ruined, at least you have the eggs in the other baskets. However, in the real world, there are innumerable types of baskets - some stronger, some weaker, some that will multiply the number of eggs dramatically, some baskets could even make your eggs bigger or more durable! With these trade-offs, diversification becomes more nuanced and complicated. In other words – what exactly are we diversifying and what is the trade off?

Diversify what?

In the world of investing, these criteria are almost innumerable. Do you want to diversify by currency: GBP, US$, CA$? By region: North America, South America, Asia, the Caribbean? Or instead by country: U.S., Canada, U.K., Brazil, Mexico, China, Guyana, Trinidad, Jamaica? How about by industry: the car industry, the financial industry, telecommunications, utilities, energy, technology? What about by asset class? Bonds, stocks, pooled funds. What about by risk? The list is endless.

How to start

You must start by setting some “fixed” criteria that you are comfortable with. For example, currency. The US$ is still widely viewed as the benchmark currency of the world. An important consequence of this is that there is a wider array of investments available in US dollars than in British Pounds for instance. Ironically, by concentrating your funds in US$ (i.e., reducing diversification) you can get a broader range of assets to diversify along (i.e., increasing diversification).

Start with US$

Generally speaking, an individual investor can feel comfortable retaining US$ as the primary currency of his or her portfolio. If you have third currency expenses (e.g., Australian dollars, Hong Kong dollars, Chinese Yuan, Japanese Yen) - then you can seek advice on how to manage this cross-currency exposure. Just because you have expenses in Yen, Yuan or British Pounds does not mean that you need to keep a portion of your investments in these currencies. If the currency is weakening against the US dollar, it suits you to keep your funds in US dollars and convert when you have expenses in the respective currency. Conversely if the currency is strengthening against the US dollar, then it would make sense to keep your funds in the currency of your expenses. Cross currency risks for very large portfolios (e.g., pension funds, sovereign wealth funds or endowments) are managed through forward contracts or other forms of derivatives. For the average investor, it is a safe enough bet to stick to US$.

 In my next article, we will discuss other criteria to “fix” and what we believe are the most important questions to ask around diversification.

Marian Ross is Vice President, Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

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