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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35392  
Subject: Thinking About Diversification Date: 2/19/2006 4:01 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.”

Jack,

It is also irresponsible to advise anyone owning those two bonds that they are NOT diversified unless you are both able and willing to lay out a comprehensive theory of diversification, which you have not done, nor has anyone on this board done so. Therefore, anyone who comments on the holdings of that (presumably hypothetical) bond holder is speaking from ignorance, which is not unusual when it comes to talking about money and investing. To paraphrase a cynical comment: “Those who can, invest; those who can't, post.”

In his book, VALUE INVESTING: A BALANCED APPROACH, Marty Whitman claimed that it was meaningless, within the context of value investing, to talk about risk. He explicitly stated:

“There is no general risk. There is [only] market risk, investment risk, securities fraud risk, excessive promoters' compensation risk, and so on.” (p. 22)

I would argue that the same point could be made about diversification. There is no “general diversification” that can be obtained in fixed-income investing through the deployment of a pre-determined, one-size-fits-all amount of capital to buy a certain number of bonds.
Instead, there are only specific types of diversification strategies can might prove effective in mitigating specific types of risks.

Thus, I would repeat the claim I made in an earlier post that buying a single Treasury bond created a diversified portfolio. The words that I assumed were understood in the context of that particular discussion were these: “default risk”.

Buying a thousand Treasury bonds (of whatever maturities) does no more to protect against default risk than does buying a single bond. But choosing the issuer can be a sufficient strategy for protecting against default risk, and it is the only strategy for protecting against default risk that is available to those with insufficient capital to pursue alternative strategies. Therefore, a person with limited capital can own their own bonds and be diversified. They do not need the $50,000 that is so self-interested pimped by the financial industry. In buying that one Treasury bond, the investor might not have protected himself against a gazillion imaginable risks, but he has protected himself against default risk, which the financial industry regards as the 800-pound gorilla that cannot be avoided unless a would-be investor has $50,000 to deploy in bonds.

I challenge you to attend the workshops that are pitched at beginning fixed-income investors and keep track of the types of risks that are talked about. Default risk is likely to be the only risk that is talked about, and the argument always goes like this: Bonds are very complicated instruments. You do not have the expertise necessary to keep yourself out of trouble. However, we do. You do not have the capital necessary to keep yourself out of trouble. However, we do. Therefore, we will do you the great favor of managing your money for you at the low cost of our industry-competitive fees.”

Jack, I'm not picking on you specifically. But what I find infuriating is the persistent attempt to scare people away from owning their own bonds and the shabby arguments offered to justify bond funds as the solely appropriate vehicle for those with limited capital. For every investing/trading risk that can be identified, there are many defensive strategies can be devised and deployed. The investing task simply becomes a matter of identifying risks that are important to the investor and then guarding against those risks in cost-effective, time-effective, and skill-effective ways. This means that, often enough, some investments/trades have to be backed away from. They are too big to do, too risky to do, or simply not worth the effort. But it also means that a lot of things that are conventionally regarded as “too risky” can be done quite safely. In fact, finding such inefficiencies can create an effective “edge”. Thus, maturity risk might not be an important risk to an investor. In such as case, two bonds might be an adequately diversified portfolio, all other things being equal, which, of course, they never are. But it's for the individual himself to identify the risks that have to be protected against, not external observers with other agendas.

That's what a beginning fixed-income investor needs to be told and what she or he needs to realize, that a whole lot more of the investing world really is available to them that the entrenched interests want investors to realize. So genuinely, self-directed investing is the very last thing the middlemen want to encourage, because they would be out of a job. My claim is that whatever the so-called “experts” can do, an individual can likely also do if they really, really want to do it and they are willing to learn how to do it responsibly. This mean, of course, that they had better develop for themselves a theory of risk management instead of depending on the generally irrelevant advice of others and the vacuous warnings of “not being diversified”.

If a person knows that they know what the term “diversified” means operationally within the context of their own investing, then they are the only proper judge of their portfolio and its risks and the only proper judge of whether the risks that can be mitigated through diversification (which is not all risks) have, in fact, been mitigated. All else is the chatterings of the ignorant or the envious.

Charlie
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