One of the great benefits of my association with DFA was the opportunity to work with some of the brightest Financial Economists in the world. Perhaps the best and the brightest was Noble Laureate Merton Miller who was brilliant but very humble, at the same time. After his long distinguished career studying financial markets he was always quick to say, “the only thing we know for certain about investing is that diversification is your buddy.”
As an investor, or a financial advisor, we need to remind ourselves of this basic rule of successful investing from time to time. It’s not all that difficult because the market always gives us useful lessons to reinforce the message. I am talking about all those “unanticipated events” which define the future. Sometimes it’s a natural disaster such as Katrina. Or perhaps industrial disasters; such as the BP oil rig fire; the Exxon Valdez spill; the Union Carbide Chemical Plant fire in India. And other times, it is simply fraud, (think Enron) perpetrated by “cooking the books.” Last but not least, the incompetence of senior management.
A couple of weeks ago the market gave us another surprise which caught the “experts” off-guard. J. P. Morgan is, (or was), the LeBron James of Wall Street Banks. The perfect model for Wall Street, which demonstrated how a large financial institution can: (1) be a commercial bank, (2) an investment bank and (3) a hedge fund, without risk to the financial system. Surprise! J. P. Morgan announced a “trading loss” of up to $7 Billion, speculating in a market they did not fully understand.
Years ago, when I was studying for my MBA, nobody wanted to be a banker. It was a good business but incredibly boring. As an auditor with Arthur Andersen you never wanted to be assigned to a bank audit, all the action was in real estate and technology. But not today! If you’re lucky, banking can give you the opportunity to speculate (gamble) with other peoples’ money. And the potential monetary rewards are off the charts.
What does all this have to do with diversification? In spite of audits and regulations, do you think that the shareholders really know what these banks are doing? Apparently, the top management of these banks haven’t a clue, so how could you or I? So what is the answer? We diversify! Going forward, J.P. Morgan and the other Wall Street Banks may do very well, or they may not. I have no way of answering that question. But the great thing about diversification is, I don’t have to know the answer.
I am more than happy to earn the “capital market rate of return” from my passively managed “well diversified” portfolio. I can’t predict the future, but I can manage the risk that comes from all the surprises that await us.