Diversification Works to Absorb Volatiliy

Most of the people we speak with consider themselves conservative investors. You probably do too. And if you were asked if you were also a prudent investor, you might answer “yes,” and see no difference.

But the difference is huge. And ignoring the difference can be hazardous to your wealth.

“Conservative” is a Feeling; “Prudence” is Objective

Calling oneself conservative is a generally subjective opinion. It has a fluid definition that basically says, “I’m trying to be careful.” On the other hand, prudent investing refers to a technical term whereby your investments, estate plan, spending plan and goals are all aligned according to the Uniform Prudent Investor Act. One major difference is that the prudent standard is objective, while each conservative investor has ideas of his own. prudent portfolios have more structure to them and have definite similarities among them, because they follow the rules of law. In our experience of looking at hundreds of various portfolios over the years, all belonging to conservative investors, no two ever seemed alike.

Conservative and Prudent Investors Want Safety Differently

In a casual conversation, both Conservative and prudent investors will agree on the importance of safety. The conservative will initially think he is risk averse, but he takes more risk than the prudent investor. When the subject of taking on aggressive stock positions or “risky investments,” comes up, a sometimes heated disagreement will arise.

Before we talk about how prudent investors like institutional pension funds manage risky assets, let’s address the way most conservative investors handle them: They don’t.

A conservative investor, because he wants to preserve principal at all costs, usually shies away from what his gut tells him is “too risky.”

Prudent Investors Seek to Capture Return Safely

If you want to be a prudent investor you have to think harder than that. A prudent fiduciary will calculate an optimum choice of which stocks to buy and how much money should go into each stock. To figure out this optimum mix, he will need to know the covariance of every investment with every other investment. An expert keeps track of these many covariances in a large table of numbers, called a covariance matrix.

You need to capture equity premium everywhere you can find it, and then figure out how to reduce the risk at the same time.You’ll reduce the risk by finding out how each investment relates to every other one in terms of its return over time. In shorthand, you’ll determine the covariance of the investments with each other.

Your total investment portfolio should have a lot of different investments to consider. The key to prudent risk reduction is to determine how the investments may correlate with each other over time. Some stocks, like Berkshire Hathaway A and Berkshire Hathaway B, have perfect correlation. There’s no point in owning both. Lately, there have been a number of Exchange Traded Funds that have almost perfectly negative correlation with a particular index. Those are more interesting and we hope to have a discussion about those posted soon. Effectively, those funds can cancel all or part of the risk across a wide variety of investments.Everyone knows that to be safe your investment portfolio should be “diversified.”

Diversification has Measurable Parameters

Diversification is a technical term which means you have a variety of investments that don’t correlate with each other very well.

How do you choose among possible different investments? You could just throw twenty darts at a stock market page and buy the same dollar value of the twenty stocks that you hit. Journalists and some pundits would tell you that this would not be a bad choice.

Unfortunately for the casual investor, “not bad” is not good enough.