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Diversity: Investment's Central Ingredient

Christian Armbruester, 8 May 2019


Diversity is often touted as commendable and it is particularly necessary in managing clients' financial lives and not just in simple portfolio terms.

Everyone (well, nearly everyone) likes to talk up the virtues of diversity. In many cases, this can revolve around issues of gender, race and ethnicity. But if the 2008 financial crash and other episodes teach us anything, it is that diversity of opinions and avoiding complacent consensus, sometimes aggressively enforced, is also really important. The years leading up to the bankruptcy of Lehman Brothers and subsequent events were marked by a great deal of apparent agreement about the benign role of central banks, government support for housing, the reliability of banks’ risk models and value of vast derivative markets. A bit more diversity about all of these views might have helped stop the crash.

Diversity, therefore, is a diverse topic. And to write about this issue from a family office perspective is Christian Armbruester, founding principle of Blu Family Office, the European firm. This publication is pleased to share these insights and invites readers to respond. Email the editor if you wish to join the debate: tom.burroughes@wealthbriefing.com

Everyone knows you shouldn’t put all your eggs into one basket. And the word “diversification” is probably the most overused term in financial marketing since “risk management”. Everyone does it, everyone has slightly different opinions on how they do it and, of course, we are dealing with an almost infinite universe of different products and strategies in a world that is still random. So how does one really diversify, without getting lost in the jargon and complexities?

Foremost, we have to look beyond asset classes and the prevailing model of classifying everything according to stocks, bonds and alternatives. From a risk perspective, the problem with stocks and bonds is that both are listed on exchanges. That means both carry a great deal of so-called “market risk”, which essentially means, that if the holders of nearly $300 trillion of global stocks and bonds decide to sell, everything goes down.

The problem with “alternatives” is that it can mean many different things, from a piece of art, hedge funds or even venture capital. The other issue is how do you value such an opaque group of investments or, worse yet, how can you know how this group of investments will behave when stocks and bonds also go down?

Our goal is to make sense of this world, in a way that we know when we want to buy apples, we actually get apples, and not some strange derivative at an inflated price. No more so than in finance do you want to get what it says on the tin, and you get what you pay for. In other words, don’t go into this exercise looking to do things better or smarter, or that you will in some way find the holy grail. No one knows.

That’s the beauty of the whole thing and it is what makes it work, because everyone knows that we can all make transactions for a price, but we don’t know where that price will be tomorrow (e.g. no insider trading).

Now that we have left our own hubris at the door, let us explore what it is we can do to improve the net returns of our investments. For one, we know we need to avoid losing large amounts of capital. This may seem obvious to most, but it bears repeating: it is harder to make back the money that we lost. That has to do with mathematics, and when we lose 50 per cent of our capital, we have to make 100% on what is left to get back to where we started. On the other hand, we have to take some risk, because otherwise we also can’t make any money. The more we risk, the more we can earn, so this is also a very personal question that is best left up to the investor. Most people are comfortable with losing 20 per cent of their capital to make adequate returns. Whatever we decide, it’s much more important to make sure that this is also what we can actually lose, when something bad happens. 

The worst thing we can do, is not knowing how much risk we really have taken on. If you have deliberately chosen a low risk investment strategy and commensurately accepted low returns (maybe for many years), to then lose a large part of your money on some random event would be suboptimal. The only way to ensure that we can survive any (random) event, is to allocate our investments into different types of risk. There are only two basic risks, that of ownership in which case our risk is the price at which we acquired said asset, and the other is credit risk, in that we can lend money to others and the risk is that we don’t get our money back. Stocks and bonds carry these two risks, but there is no such thing as an “alternative”. There is only price and credit risk, everything else is a just a form thereof.

Most popular is the so called “beta” category and this includes assets such as stocks, commodities, commercial property, or private equity – anything we buy (for a price), the risk is that the price goes down. Very different is the infamous “alpha” category, whereby we take relative price risk and instead of falling prices, we take views on how two financial assets might react relative to one another. Often these investments are wrapped into investment vehicles called “hedge-finds” and so long as you find managers that don’t take absolute price risk (to charge high fees), then this form of price risk is very different to that of the former (beta). Finally, we can also take views on specific prices (gamma) and this includes speculating on events, a particular venture or other forms of concentrated risk – all relating to one price, or an event happening the way we expect it to, or not.  Absolute, relative and specific forms of price risk by their very nature are different and therefore perfectly diversify any investments we make to gain upside.

On the credit side, the objective is not to make lots of money, but to put that what we have to good use and lend it to someone else. Depending on how sure we are that this someone else will repay our money, we can charge interest commensurate with the risk we take on. Most secure are loans to the government, then to corporations and lastly, we can also lend against the security of a specific project, asset, or other forms of structured credit risk. Of course, the quality will vary greatly from one country, company or project to another. But this is true of everything, and getting exposure to the various forms of risk through the best products, managers and instruments is a whole other story.

Summing it all up, if you allocate your investments across all the different forms of price and credit risk, your capital will be protected through true diversification and if you are efficient in your implementation, you will also be able to keep most of the returns from the risks you take on.

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