Risk Management

I of course agree that investing in one stock or small number of stocks is generally riskier than investing in a broad index. Diversification is wonderful.

But the theme of this series has been how little we really know today about how stock investing works in the real world. I think that theme applies again and that we need to be careful about assuming that indexing is always a way to avoid risk.

What happens when stock prices go so high that a price crash becomes inevitable? In that circumstance an index is the worst place to be. An effective stock picker might find the few stocks that will not suffer bone-crushing losses in a crash. The indexer will not. By indexing, you tie your fate to the fate of the market as a whole. You lock yourself into experiencing a bone-crushing loss sooner or later.

The root error here is the failure to give cash-like assets the recognition they merit in crafting a truly diversified portfolio. People are dismissive of cash because it provides low returns. What they miss is that any asset class that permits you to avoid bone-crushing losses during a time of overvaluation is opening up opportunities for huge gains at other times by doing so. The real returns for investing in cash at times of insane overvaluation can be astronomical. Those who lowered their stock allocations before the crash will be obtaining compounding returns on the gains they obtained by doing so for many years to come.

We don't really understand today what diversification is. It's not just being invested in different kinds of stocks. It's being invested heavily in non-stock asset classes at times when all stock classes are priced to provide poor long-term returns. We need to rethink the diversification concept to make it truly helpful for middle-class investors seeking to invest successfully for the long term.

Rob

"This is not diversification—it’s just expensive"

That's a great way to put it!

I'm not as convinced with #4. I think making decisions about risk management of investments tied to the same industry as your income could potentially be just as risky because it introduces new uncertainties (other risks). Is a doctor's income impacted more by events in the pharmaceutical industry or the financial and insurance industry? How about food and beverage industries? Technology? I think it depends on what exactly those events might be. There may even be a argument for the travel and leisure industry having an impact on doctors.

There are probability examples that I cannot even think of, and thats where I think even more risk can be found. My point is that similar factors can be considered between many industries and occupational incomes. I just wonder if attempts at mitigating such industry risk by shifting risk toward other industries that are perceived to have a lower correlation to one's income could just as easily back fire. I don't know the answer, so I tend to view that as a risk best managed by not attempting to out guess it.

Good point Dylan. I guess my point is that having concentrate exposure to
one industry is one "risk" that might be easy to "manage". I think it would
be silly for a doctor to also have the majority of there investments in drug
stocks. It is silly for a salesperson at CISCO to have most of there money
in tech stocks. The risk that they get laid-off is highly correlated to
having the stock down.
That being said it is not smart for anyone to have concentrated exposure to
one industry, but it tends to be folks that work in the industry that do it.
They think that because they work there they have special insight into the
future performance of the stock/industry.

That is dangerous.

I agree that it's not smart for anyone to have concentrated exposure to one industry. I think I might have misread your original post, thinking you meant one should underweight the industry they work in relative to the market. I get it now.

If you are an expert in a particular asset class then you are increasing risk by going in to asset classes that you do not understand. Stick with what you know, there are going to be ups and downs in all asset classes but the well informed knows when to get in and out.

Don't forget. Company stock in the 401(k) plan adds a lot of risk.

Also, consider all of the lifers at AIG who thought that all their worries would be covered through the AIG stock purchase plan (which was subsidized), and induction into Starr International (infrequent, but if you were really loyal, wow). Now those are broken. Sic Transit Gloria. (et pecunia...)