On Why Diversification? – Part One; A Healthful Diet Prevents Heart Attacks!

From: aditya rana
Sent: Saturday, September 27, 2014 3:24 PM
Subject: On Why Diversification? – Part One; A Healthful Diet Prevents Heart Attacks!

Hi!,

Diversification is a basic building block in the management of an investment portfolio and is a theme I have emphasised in numerous past newsletters. That the future is uncertain is a given in the world of investing, and diversification is a key tool in navigating this unpredictable future. Ben Carlson, an experienced portfolio manager and financial blogger wrote a series of notes recently (http://awealthofcommonsense.com/diversification-investment-cycles/) on the subject which illustrate the merits of diversification. To summarise the first part which covers how diversification can help smooth market cycles (the second part will follow next week):

“A great deal of data, and all my experience, tell me that the only thing we can predict about cycles is their inevitability.” – Howard Marks

Howard Marks, the CEO of Oaktree Capital, in his book "The Most Important Thing" explained the fundamental nature of cycles as:

-"I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future."

-The problem is that each cycle is different in its characteristics – its duration, fundamentals, market leadership and its relation to the business cycle. So it’s hard to appreciate that (a) the good times will eventually end, and, (b) the bad times won’t continue forever.

-The tendency for investors to sell low and buy high is clearly illustrated by the following graph which plots flows into mutual funds against the performance of the market:

-The cyclicality of markets can be seen by looking at the following tables which show the performance of various asset classes over long time periods.

-The S&P 500:

-International stocks:

Small cap stocks:

-Emerging market stocks:

-Real estate investment trusts

-Given the above cycles, investors tend to capitulate at the wrong time: saying "Returns have been terrible for a number of years now. I’m done, or, Look at how great these returns are. I’m in."

-Investor psychology plays a key role in this process – while greed drives investors to take risk, it are the losses which leave the big scars on investors. People bail out of markets only when they are losing money – not when they are making money.

-This is where diversification can play a key role as it helps smooth out the worst points in an cycle and you do not give up on your investment plan at the wrong time.

-Looking at the performance of a simple diversified strategy involving an equal weighting across the above five asset classes, during the down cycles for each of the asset class:

-Diversification substantially improved the performance during the down cycles for each of the asset classes, and while they would have underperformed during the bull markets for each asset class, it is importance to understand that diversification is about balance and being able to survive over the long haul.

– Taking a look at the 3, 5, 10 and 15 year annual numbers for the five asset classes it is clear to see how diversification leads to more steady performance over time:

-A diversified portfolio is never to hot or too cold. Since 1995, at least 60% of annual periods saw one asset class ending in the negative, and 40% of the time two of them did so. But the diversified portfolio was positive 75% of the time.

-While theory tells you that diversification gives you the highest return for a given level of risk, the key benefit of diversification is not bailing out of your investment plan at the worst possible time.

To be continued next week.

A simple yet powerful illustration of the benefits of diversification. Diversification gives you balance (an application of the ideal of "the golden mean" or "middle path" as espoused by various ancient religions and philosophies across the world)- and as long as one is patient, it can also provide you with a superior return lover the long run.

What is an appropriate base case diversified portfolio? – in my case (it will vary depending your own particular requirements and tolerance for risk) it’s 40% global equities, 40% global bonds and 20% cash, with variations around the base case based on current valuations for the particular asset class. Within each category the asset classes included would be developed world stocks and bonds, EM stocks and bonds and country allocations are again based on long-term valuations measures (Cape/GMO approach) for the particular asset . While achieving an appropriate diversification can be quite easily done – the hard part is the discipline required to rebalance the portfolio periodically.

Healthful Diet Prevents Heart Attacks:

Came across some interesting research which quantifies the benefits of a healthy diet, amongst other factors, in reducing the risk of heart attacks:

PRCM; 26/9/2014:

http://content.onlinejacc.org/article.aspx?articleID=1909605

Lifestyle choices, including a healthful diet and exercise, may prevent four out of five heart attacks, according to an article published this week in the Journal of the American College of Cardiology.

-Researchers assessed five low-risk health factors among 20,721 Swedish men for 11 years. Those who avoided smoking, had moderate alcohol intake (10/30 g per day), exercised (walking more than 40 min/day and exercising more than 1h/week), had the least amount of belly fat (waist less than 95 cm), and consumed the most fruits, vegetables, whole grains, and legumes.

-The men who had all five low-risk factors had an 86 percent lower risk for a heart attack, compared with those who did not meet these criteria.

-Not smoking and eating healthfully had the most powerful individual effects, reducing heart attack risk by 36 and 18 percent, respectively, compared with people who smoke and ate poorly.

-The combination of healthy factors was present in only 1% of the population, and the researchers estimate that the program utilized in this study could reduce the burden of heart disease by as much as 79 percent.

The evidence in favour of maintaining a healthy lifestyle and diet continues to mount – and it’s a daily choice (for better or worse) we can make and contribute years to our life and life to our years!

Regards

Aditya

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