Lies, Damn Lies, and Statistics

“There are three kinds of men. The ones that learn by readin’. The few who learn by observation. The rest of them have to pee on the electric fence for themselves.” Will Rogers

The Truth about Diversification

 My favorite scientific journal, People Magazine ran a story about a couple in Philadelphia in the 1970s that saw the first Rocky movie. Sly Stallone beat all odds in the boxing match of a lifetime gaining fame, Adrienne, and investments in condominiums (which he claimed to never use). People said the couple sold all of their possessions and put it all on the lottery. Everything. They showed them waiting for the results, sitting on the floor in their apartment with no furniture, no TV, and weary smiles on their faces. They did not look comfortable. They never ran a report on what happened. Since that would’ve garnered a lot of attention and magazine sales, I think I know what happened.

Most of us don’t wake up wondering how to risk losing our stuff. We like stuff and we like predictability. We drink the same coffee, use the same toothpaste, and read the same newspaper.  We build things up over time in life’s journey. Life toppled is unexpected and undesirable. We would rather make money and everything about it absolutely guaranteed. Why then is it that financial advisors keep telling us they have the answer to lower risk. If there was an absolute answer, the entire investment industry would not exist. Instead, we are told we can lower risk through diversification and just holding the same investments no matter what. It’s easy to buy into. We hear logic like “I have enough time until I retire. It will all work out ok. If the market is down, I have plenty of time to recoup the loss. I will have enough money in the nick of time just before I retire.”

This is called TIME diversification. It is considered the first level of diversification.

Time diversification explained, demystified, and debunked.

Time Diversification Explained and Demystified

Let’s say that you have $50k to use for a home purchase down payment in six months. You would likely invest this in a very safe, low yielding account because you really need the money to be there. Conversely, imagine that you have 20 years until your child is off to college. Chances are you would invest in more risky assets for it because you have more time.

·         For the six month need, you would tend to use a risk-free asset. It makes sense. If you were to put the down payment in the stock market you run the risk of loss causing you to forgo the new home.

·         For the twenty-year college need, you might tend to use the stock market (risky) because over a 20 year period you expect stocks to have a higher return and you also expect poor performance to be offset by great performance and generate returns close to the long-term averages.

This is time diversification. Higher returns offset lower returns over a long time and converge to the average long-term return. Part of this is the mathematical truism that over time risk (measured by standard deviation… Please don’t start yawning) decreases by the square root of time. Yep, that’s mathematically true. Here is the other truism.

Time Diversification Debunked

While your average risk is declining and converging to a long-term average, your wealth diverges from an expected average.

1. You are less likely to lose money over a long time horizon than over short one, 
2. But the magnitude of your potential losses increases with time through compounding,
3. Number two exceeds number one.

An example shows this: Suppose you have the opportunity to invest in a risky venture with $10k. You decide it’s too risky for you and you decline. Next, you are offered 10 of these ventures for an investment of $100k total. This lowers your risk compared with the previous $10k investment opportunity by spreading your nest egg across 10 different investments. Because this diversifies you, you should be less resistant to invest. The magnitude of your potential loss is now $100k. Your risk has declined but the magnitude of your potential loss has increased.

So, in this case the statistics make honest the lies and damn lies. Ultimately, in order to make retirement really happen in the way that you want it with low risk, you need to choose the risk with which you are comfortable from the get-go and stick with it until you retire, because the magnitude of your potential losses increases over time. Once you retire, you need to reevaluate your risk because your retirement nest egg will need a reboot to produce income.

You might just find that a guaranteed account for 3% beats the pants off of your long-term stock market investment. We’ll talk about that in the next installment of  "The Truth about Diversification".

Please feel free to call us at Private Wealth Counsel of Minnesota, LLC, at 952-230-1340 if you have any questions or would like to talk.

Regards,

Chris

Diversification cannot guarantee the protection against a loss nor guarantee a profit. All investing involves risk.

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