Diversification in Your Portfolio
A Supposed Truism – “Mitigate Risk by Investing in Different Sectors”
We are constantly barraged with advice from our financial advisors insisting that the way to make money and to minimize risk, is to widen your scope of investing. We are constantly advised that having a percentage of your portfolio in foreign markets is an essential thing to do.
How to Invest Where You Don’t Know the Ground Rules
Investors often heed this advice by buying a basket of stocks in the BRIC countries, or in Asia, or in China – the current hot market. Often it appears that the safest way to do this is to buy a mutual fund or an ETF that holds stocks of those countries.
Choosing the Mutual Fund or ETF
My opinion of mutual funds is pretty dismal, and my belief is that the only people profiting over the long term are the managers of those mutual funds.
That leaves ETF’s. If you believe a sector will have sustained growth over the next while, and if you are not familiar enough with specific stocks from that sector, sometimes an ETF is the way to go.
The Most Common ETF Pitfall
Investors chose ETF’s on the basis of their past performance. There is always a caution in the literature that “Past Performance is not a Valid Indication of Future Performance“. That is a very accurate statement.
When a particular sector or region does well, the ETF’s covering that sector always have an excellent track record. Unfortunately, that key indicator of whether an ETF should be purchased, is misleading more often than not.
I urge the reader to consider whether to buy a particular ETF much more on your belief as to what is about to happen in that part of the world, or in that sector, than on any other criteria. Only after that key decision is made, should all other comparisons be made.
Consider China
ETF’s covering China have done remarkably well as the Chinese “Miracle” unfolded. Recent performance on the other hand has been anything but. Consider some of the recent news.
Overall World Stock Market Performance
Consider that North American and World stock markets have been in the doldrums for some weeks now. Stock values have drifted, usually a bit lower recently.
Chinese Based Companies
Recently, a major Chinese forestry company lost almost 3/4’s of its value after accusations of impropriety surfaced. A second company doing business in China and listed on a North American stock exchange had issues and a similar fall in its price. Have you read in the newspapers about the major losses incurred by ‘sophisticated’ holders of those stocks?
Chinese ETF’s
July 5 2011 Bloomberg – China ETF in U.S. Loses Most Money as Mainland Brokers Say ‘Buy’. The biggest Chinese exchange-traded fund in the U.S. is losing money faster than any other country focused ETF…….
Chinese Debt
In a future blog, we will discuss “Off Balance Sheet Financing”. If you read behind the headlines, the massive Chinese capital projects are for the most part financed by Off Balance Sheet Debt – similar to the wonderful financial vehicles that almost destroyed the Western World economies in 2007 – 2008. A remarkable new twist on a remarkable old theme.
If you believe that “THIS TIME IT WILL BE DIFFERENT“, you should ignore all the warning signals. Just remember, in spite of all of the financial writers forecasting changes, it is almost never different. What seems too good, too “hot”, too much a new paradigm in the world, – usually isn’t. It just takes some time to crash and burn.
Mitigating Risk
If on the other hand, you want to reduce your risk, you will avoid gambles like the ones described. Instead, consider the following as some of the basic rules of investing:
– Invest in companies that are understandable
– Invest in companies that operate under rules, regulations and customs that you understand
– Be cautious when things appear too good
– Everything works in cycles and no cycle continues forever
– Diversity of investment is a good policy, but it must be considered carefully. Often, it means that if you gain in one sector, you lose it in another – doesn’t sound very “safe” to me
– If you buy a mutual fund or EFT that mirrors the averages, you are betting on the general economy. Paying someone to buy an average is less than wise, especially when after paying commissions and expenses, it is generally impossible for that investment to equal the average
– Stock markets averages are inherently misleading. An advisor, mutual fund or ETF should be picking stocks based on a belief as to future prospects of a particular sector. An average is just that – an average.
