Diversification is, at its root, a response to the ancient admonition you might have learned from grandma: don’t put all of your eggs in one basket. If that basket drops they could all break, ruining your and grandma’s breakfast! This proverb can be traced back to the 17th century, and was popularized by Cervantes in Don Quixote[1]. (Later, Mark Twain, ever the contrarian, proposed the exact opposite: “pull all your eggs in the one basket and—watch that basket!”[2]
The wisdom of Cervantes goes nearly unquestioned today. Virtually every reputable financial firm teaches people about diversification, extolling the importance of spreading out risk. But—and this is an important but—we contend that however well intentioned, Wall Street’s version suffers from two major omissions: first, they focus solely on one’s financial instruments, and second, they can’t model the possibilities of Breakdown/Breakthrough, so they presume that we’ll be Muddling Through for the foreseeable future.
These blind spots have led investors to focus nearly all of their attention on investments made within a single zone (financial assets/global economy). A good financial advisor will assure that you are diversified within that basket,[3] and might even offer advice on the real estate zone (tangible/ close to home) but this is far different from being offered enough baskets to fill the Resilient Investing Map. A more accurate image is to picture a bunch of small dividers (sub-categories of types stocks and bonds) placed within the basket that contains Wall Street’s financial instruments.
So instead of following grandma’s wise advice, people are unwittingly using Mark Twain’s approach, one that was meant to be a parody! We are putting everything into one large basket, hoping and praying that we don’t trip, or that nothing bad happens to the global economy, either of which could send our eggs tumbling. This may sound humorous, but it leaves people far more vulnerable than they’ve been led to believe.
Resilient investing takes the virtue of well-considered asset allocation and applies it to a wider set of holdings. Obviously there is so much that won’t fit in Twain’s single container, including all of your Personal Assets and most of your Tangible Assets, the very investments that will serve to buoy you through the ups and downs of your Financial Assets. We’re making the case for creating a truly balanced portfolio that includes much more than you’ll ever find on a brokerage statement.
And what happens if the future is not simply an extrapolation of Muddling Through? Wall Street’s methods have worked well during many market cycles, but they offer scant protection from systemic risk—the risk of collapse of the overall market, not just a particular company or industry. In financial-speak, another word for systemic risk is “undiversifiable risk,”[4] which essentially says that there is nothing in the global economy basket that will keep you afloat when the ship goes down.
The financial crisis of 2007 – 2008 provided a glimpse of what this could look like. Real estate values collapsed, uprooting homeowners who had been lulled into a fantasy world where prices only go up. Bond prices gyrated, as the risk of default by corporations and municipalities rose, causing great distress among older investors who thought they were invested conservatively. Even gold, regarded as a safe-haven by many, sank 25% during the worst of the crisis.[5] Investors had no place to hide except under the mattress.
Nobody knows when the next shock will hit the financial system, but if there was one lesson to learn, it was that investors need to update their risk management toolbox. We’re not willing to accept that there’s no way to address systemic risks, and neither should you. A resilient investing plan will enrich your life in today’s world, while hedging against—or, if you choose, preparing for—the possibility that our fundamental economic, social, and environmental reality could shift in profound ways. Of course, while resilient investing may reduce exposure to systemic risk, we also must remain diligent and conscious of managing (and balancing) the range of specific risks inherent in our actions across the Map; this is addressed in more detail on the Resilient Investor website.
NOTES:
[1] This reference spurred some historical debate among our learned manuscript reviewers; while the phrase is often credited to Cervantes (as either the original source or repeated by him in Don Quixote), some claim it’s an artifact of one translation, and does not appear in the original. We’re going with the good story here, and letting the phrase be part of his canon.
[2] Mark Twain, Pudd’nhead Wilson and Other Tales, http://www.goodreads.com/work/quotes/104269-pudd-nhead-wilson-and-other-tales
(accessed July 22, 2014).
[3] Classic diversification includes bond funds of various kinds (private, government), stock funds including small-cap, mid-cap, and large-cap funds, global and domestic funds, index funds, sector-specific funds, etc., as well as a portion of your portfolio in “safe” savings vehicles such as CDs. Beyond these core holdings, a plethora of other financial vehicles are part of global markets, including Real Estate Investment Trusts, commodity investments, and many risk-trading products.
[4] See www.investopedia.com/terms/s/systematicrisk.asp. There are “hedging” strategies designed to mitigate systemic risk, but they are not generally used by average investors.
[5] SeekingAlpha.com, “How Gold Performs During a Financial Crash,”http://seekingalpha.com/article/295567-how-gold-performs-during-a-financial-crash (accessed July 22, 2014).
