The Logic Behind Diversification

Written by Jeff Helms

The financial world is complex and constantly changing. Those changes can impact our clients and their plans for the future. As the firms founder and Managing Partner, making sense of these changes is my job. We try to simplify communication on market dynamics to make it meaningful and useful for our clients.

February 19, 2015



The Logic Behind Diversification-media-1

When dealing with people, remember that you are not dealing with creatures of logic, but creatures of emotion. – Dale Carnegie

Last month, we introduced the concept of diversification. Since its numerous benefits cannot be completely explained in a simple paragraph, consider this chapter two of our lesson. Before we embark on extolling the virtues of your grandmother’s lesson to not put all your eggs in one basket, let’s clarify a couple of facts: 

First off, people are naturally wired to have a “recency bias”. This means that expectations are that the recent past is pretty much what the future will look like. (It’s not your fault; it’s wired into your DNA.) What’s more interesting is that, despite tons of history that the past is not indicative of the future, people tend to gravitate toward a belief that it is. We’ve seen this recently where US stocks have performed well while other investments lagged behind, and people can’t seem to get enough of them as a result.

Second, you generally have only two speeds when it comes to your money – fear and greed. (“I want the highest possible returns with no risk.”) Again, it’s in your wiring. Both of these tendencies are grounded in emotions, not logic. Sadly, there’s not much room for emotion if you want to invest successfully. Let’s look at some facts and see what logical conclusions we can draw from them:

  • It is a statistical fact that past investment performance is not an indicator of future performance. Just because a particular investment has performed well (US stocks) or poorly (oil) in the recent past is not an indication of how it will perform going forward. There is no historical basis for predicting it.
  • The future short term direction of investment markets is fundamentally unknowable. The world is full of unemployed soothsayer’s blogging away on what tomorrow will bring to your portfolio. The truth is – you’re every bit as qualified as they are to guess. Because that’s all it is – a guess. 
  • Nothing goes up forever or down forever. Instead, all investments go through cycles of outperforming and underperforming each other. We just don’t know when. (See fact #1)

If these are facts, then logic tells us the best course of action is to spread our wealth over all these investments and be patient. Every year, we’ll own the winners- and some of the losers. This diversification has the wonderful benefit of smoothing out your returns year in and year out. The best analogy we can offer is the Dames Point Bridge in Jacksonville. It spans the St John’s River at an impressive 175 feet high. The bridge has six lanes for traffic. It also has guardrails to keep you from driving off the bridge to an unpleasant end. So, a question: If it didn’t have any guardrails, which lane would you use to get across the river?

If you’re logical, you’d drive straight across the middle of the bridge. Well, that’s what diversification does for your portfolio. If you think of investments as the traffic lanes, some get too close to the edge each year. But by owning them all, you get to enjoy the middle of the investment drive each year. And if the destination is a comfortable retirement, driving across the middle lane just makes sense. This doesn’t guarantee you win every year, but it does make the ride more predictable and safer than betting which lane will get you there faster (“I only want to own US stocks, because they are doing well today.”) – and being wrong about it.

Remember the three principals we espouse over and over: Asset allocation, diversification, and rebalancing. You’re counting on us to get you across the bridge dry and on time. Time has proven these principals will help us all do just that.