“Diversification Is Your Buddy”

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.

5 Comments

Filed under Advisors, Investments

5 responses to ““Diversification Is Your Buddy”

  1. Great article Dan! Love the comment, “if they haven’t a clue, how are you”. The people that run JP Morgan were thought to be the “best”, but even they can’t guess right all the time. Why would you guess or place a bet on your financial future. Three simple rules, 1) own some stocks, 2) diversify, and 3) rebalance. Use no-load index funds and have them structured to your risk tolerances. Investing can be simple, just don’t listen to the media or Wall Street.

  2. As a relative “newbie” to the world of DFA, some of my likewise newbie colleagues get somewhat carried away from time to time trying to think of ways to simply explain standard deviation to the average investor when what we should probably do is master our talks about diversification and re-balancing. Thanks for your work, Dan! We “newbies” will fast become masters at teaching investors stress-freedom regarding their portfolios with your shared knowledge.

    • I like describing Standard Deviation as the Richter Scale for Investors. I find many clients start to get lost if you try to be too scientific. And, since you are selling a great service, not returns, you can focus on that and let Dimensional sell itself – which it does very well.

      Best wishes,

  3. Hey buddy – hope all is well in your world. This is a great lesson you shared with me twenty years ago and it has served me well. Just signed up for your letters. Keep preaching the truth.

  4. Cliff Sparks

    Thanks Dan for sharing your insight and wisdom. I think you hit the nail on the head when talking about these so called “experts”. It blows my mind to learn about the inner workings of Wall Street and some of these financial institutions. To most of these companies (including J.P. Morgan) I guess it doesn’t matter how risky an investment might be if the payoff is great or if they can see the future or not. They are using investor’s money. They win even if they lose. It would be nice to know how the CEO’s personal portfolios look in some of these companies. I’m pretty sure that it’s contrary to what they’re selling and in line with everything you’ve discussed.

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