TRUE DIVERSIFICATION

Most investors think diversification is owning different industries.  You buy a bunch of stocks and as long as you own some oil, some retail, some health care, etc you’ll do fine.  Right?  Not so fast.  Real diversification involves the trading of multiple non-correlated assets.  People often ask me: “why do you trade so many different assets”?   I’ll break that down into two answers:

1.  All assets make up one big marketplace in my opinion.  The house you bought in 2005 was purchased with debt which somehow impacted the balance sheet of a bank which somehow impacts the underlying equity in that company which impacts…so on and so forth.   It’s very hard to find an asset whose performance is not somehow impacted by other assets.  That’s why I paint the market with a very broad brush.  How can you claim to be an expert in equities without also understanding debt?  How can you claim to be an expert in gold without understanding how currencies work?  In my opinion, you have to understand all markets before you can truly claim to be an expert in any single market.

2. Jim Cramer’s is  right: there’s always a bull market somewhere.  One of the primary reasons why global macro funds perform well when compared to other fund styles is due to their diversification overkill.  A good risk manager can be long Yen, short dollars, long Fed Fund futures, short gold, long Chinese equity and short GM debt all at once.   You don’t have to pigeon hole yourself in this world.  The fund managers who call themselves “large cap growth” or something similar literally make my brain hurt.  That’s like picking up a basketball and saying: “I am going master shooting free throws, but forget how to make a lay-up”.  How will your performance be?  And how well will you do if you never get to the line?  We saw this last year.  Every long only equity manager fell flat on their face because they were pigeon holed into a niche that wasn’t performing well.  I don’t care who is investing – if you’re a large cap tech manager and the Q’s fall 50% your fund is dead in the water.  You can be flexible in this world.  Take advantage of it.

True diversification means learning ALL markets and TRADING at least a few non-correlated markets.  That’s true diversification.

Cullen Roche

Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.

He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.