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Don’t rush to diversify

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Investors constantly are being bombarded by a mantra-like litany to diversify their holdings.

Any objective observer should acknowledge this is a cop-out. Instead, what is essential is to determine if the possible loss in an investment situation is greater than the amount of a possible return.

Whatever strategies are employed to manage risk, such as hedging, dollar-cost averaging, learning to recognize traditional opinions, or reliance on that old stand-by, diversification, the immediate activity is waiting for “instructions” from the market itself, or perhaps from anecdotal evidence.

Those, however, are not money-making approaches to investing.

Diversification, in effect, means that one is not making a real judgement, but is simply relying on the market itself. Hence, if equities, in general, were to rise in price, the diversified portfolios would appreciate as a result.

Conversely, if the stock market were to decline, that group of investments would decline and the investor loses.

With diversification, if one placed funds on several sectors, say health-care companies, they presumably would gain, but financial businesses would slump if interest rates were to rise.

Hence, the balance really precludes making a possibly risky or financially-rewarding position.

On the other hand, an astute investor may infer that trouble is looming in the oil-producing regions. That would entail higher petroleum prices and investors there would make a profit.

If inflation appeared as a threat, investments in commodities make sense. If currencies were being debased, holdings in precious metals such as gold would be appropriate.

The problem, therefore, is that diversification signifies only a willingness to invest in a wide range of assets classes. Rather than that, one should avoid conventional wisdom.

There is the crowded boat effect, with high-tech securities being a classic example. Everyone rushed into that sector, so prices rose sharply. Investors were self-satisfied.

Then something happened to change sentiment. As everyone rushed out of that asset, the “boat” capsized.

The additional returns turned out to be illusory.

Thus, while diversification would have avoided that calamity, it did not lead to significant market gains. Therefore, for those who know what they are doing, they should focus on macro-economic trends and capitalize on them.

That is the best route for making investment gains—far superior to having a diversified group of company shares.

Bruce Whitestone, an economist, was educated at Yale University (where he graduated with top scholastic honours) and McGill University Graduate School.

For more than 40 years, he’s been involved in Canadian government affairs and the investment community.

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