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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35340  
Subject: Re: Thinking About Diversification Date: 2/19/2006 6:25 PM
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Jack writes: “It is irresponsible of us to advise anyone to consider themselves diversified with two bonds of equal maturity. This doesn't mean they made a poor saving or investing choice but it isn't diversified. They are fully exposed to how the market treats that one maturity.”
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Today, the prize goes to Jack. Now I know this is only my prize and worthless on the eBay market, but,

While Charlie made valid points and brings in some good arguement material, Jack seems to be speaking of interest rate risk. Charlie then counters with a diseration on default risk. NOT THE SAME THING!

So this is apples to oranges!

To me interest rate risk and time diversity are also seperate, but this is not a common view as one easily ties time to interest rate, but remember a change in near term interest rates does not equate to the same change in long interest rates. So lets look at interest rate diversity.

If you have one, two, a thousand bonds with the same maturity then you are exposed to interest rate risk in an undiversified portfolio. Now, the fact that you have some coupon payments will give a little help as the cash flow over the entire bonds is not effected the same. But the maturity date - when the principal is returned is still subject to a nasty blow. And all the risk is tied to one interest rate.

In the recent interest rate climbing environment we have perfect examples of this. Lets say you owned 10 bonds with a 2-3 year maturity. Over the last year, you have witnessed a loss of principal. This is because the short, close, near end of the interest rate curve has gone up, a lot.

But if you had bonds with various maturities 2, 5, 10, 30 (25) then you have noticed a loss on the short end but on the long end the rate have not gone up, in fact the has been a little down movement. So, the value of some long bonds have gone up. That is diversity.

Now, in recent times this has been helpful, it other times it is not so helpful. The long end is very tempremental and can crush even a strong trader. The interest rate is not as volatile, but the end multiplier on value is.

So, two bonds with the same maturity does not really diversify interest rate risk. How many would depend on your feeling about the interest rate curve. This may be an interesting mathematical exercise I may tackle if some time is available. I guess you would want to see what maturities would reduce volatility to a minimum and then call a 90% reduction - diversified???

So, I guess I am irresponsible, because I have not laid out a plan for divesification, Sorry Charlie, this ain't starkist! But - one, two or a thousand bonds with the same maturity is not diversified for interest rate risk. And if they are all from the same issuer, then not for default risk either.

"It is irresponsible of us to advise anyone to consider themselves diversified with two bonds of equal maturity"

If anyone thought that my example of one bond meant that one bond diversified all risk, interest rate/liquidity/re-investment or charlies default, then that was my bad. Each of these require attention and some adjustments, but one thing that is common - the more maturities the better for each of topics.

DrTarr

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