Does Diversification Reduce Risk?

Does Diversification Reduce Risk?

Blue Line Investing, Article 7 of 12

 

Stocks? Check. Bonds? Check. Real Estate? Check. Commodities? Check. “Don’t put all your eggs in one basket” as they say. You are likely familiar with this saying, and in theory we believe it is prudent advice. But when it comes to actual implementation, does it make sense? Presuming you are already familiar with the potential benefits of diversification, we believe the answer to the title of this article is yes – diversification can reduce investment risk – but at what cost?

Diversification can help reduce the risk to your investment portfolio depending on your asset allocation. Asset allocation is how you choose to invest your money among categories of investments like those listed above.  Some categories are considered “risky” (such as stocks, real estate, and commodities) due to the potential volatility of their prices, while others are considered “risk free” (such as bonds and cash equivalents) because the volatility of their prices is more stable. It is this asset allocation decision that will likely have the largest impact on how much you reduce risk as you diversify your investment portfolio.

But therein lies one of the main costs of diversification – the more money that is allocated to “risk free” investments in attempt to reduce your risk, it will likely lower your expected rate of return over the long run. And further, the more you broadly diversify your investments within each of the categories listed above, the more likely you are to own investments that are in both rising and declining trends. It is those investments experiencing negative primary trends that detract from your total portfolio returns. So what can an investor do? Is there a way that can help to reduce risk without necessarily having to limit the potential return on your portfolio? We believe the answer is yes.

We have found that when a publicly-traded investment falls below its blue line by more than 5%, it may be the markets way of providing an early warning to investors. When this 5% warning happens, and if thereafter the investment’s price goes through the next 2 steps of our sell discipline, then we believe there is a high probability that prices are now in a negative primary trend and will continue to fall further. At that point in time we believe the investment should be sold. We believe it is preferable to identify and own those investments that trend above their blue line while avoiding those that, at least at that moment in time, do not.

While we believe diversification can help reduce risk, we believe it is likely to lead to an average return over the long run. For investors striving to achieve an above-average return instead, we believe a sell discipline (not a substitution discipline) is required in your investment process. Our next article will distinguish this difference.

Disclaimer:

Past performance is not indicative of future results. This material is intended for educational purposes only and is not financial advice or an offer to buy or sell any product. The investment strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. The opinions expressed are those of Blue Line Investing and are not necessarily those of Gordon Asset Management, LLC and are subject to change without notice. Blue Line Investing reserves the right to modify its current investment strategies based on changing market dynamics or client needs. Advisory services offered through Gordon Asset Management, LLC (GAM). GAM is an SEC-registered investment adviser. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (866) 216-1920. The principle office of Gordon Asset Management, LLC is located at 1007 Slater Road, Suite 200, Durham, North Carolina, 27703.