Saturday, March 7, 2009

The Case for Diversification

Why should you diversify your investment portfolio?

There has been a lot of fuss about schools losing a large % of their endowments. The most famous endowment of them all: Harvard has lost 8 billion$ out of 36 billions$ in ONLY 4 months!! (Of course this is only paper value loss, and if or when the USA get back on track, the fund might regain its value back).

What are endowments?

Money that is given to an institution can be spent right away OR they can save it and make it grow. When you save the money from donations, and only spend the money you earn through investments, that is called an endowment. Big name schools tend to have endowments.

Harvard Portfolio Pie Chart from 1996:

That amount to a whopping loss of a whopping 22%. Even Burger King whoppers are trembling in fear.

In my part of the country, the public Quebec Pension Plan Fund administered by the Caisse de dépôt et placement du Québec has lost 40 billion $ out of its 160 billion $ reserve in its 2008 report. That translates to a 25% loss in one year, similar to what the Harvard Fund is facing.
Since this is a public fund that every Quebecer who works has to contribute too, it has been shown as a national disaster on TV, since it affects everyone, especially the senior citizens who are about to retire. A 25% loss is normal in this kind of economic climate, and yet there probably will be a provincial inquiry on how the fund is managed and what kind of risk models the managers are using.

Quebec Pension Plan only expects to pay for 25% of your retirement costs :


How do these losses compare to what's happening in the stock market?

Take a look at the S&P 500, was at 1160 at the beginning of October then by beginning of Feb was 830, so in 4 months, it has lost 28% of its value (compared to 22% at Harvard).

One year ago (Feb 2007), S&P 500 was at 1300, that translates to a one year loss of 36% (compared to Quebec's pension plan loss of 25%).

And as a benchmark, the Dow Jones has lost 28% in 4 months also, and 35% in one year. Numbers that are very comparable to the S&P 500.

What can we learn from this?

It's a well known fact that the vast majority of fund managers can't beat the indexes (which points to how useless they are since you have to pay them EXTRA just to manage the fund, and they collect some of the profits too).

But in this case they actually did perform a little better, why is that?

Because they did not solely invest all of their clients money in STOCK!! You need to diversify: invest in bonds, money markets, treasury bills, etc. You should also invest in different industries and countries. So if one market takes a huge hit (like stocks in our case), you can minimize your losses.

Even though their portfolios are diversified, why did these funds take such huge losses?

To make big gains, you need to take big risks. Both the Harvard and Quebec funds were making big gains over the years, mainly because they invested in some risky financial instruments (such as commodities, private equity funds and mortgage-backed assets - Asset-Backed Commercial Paper - ABCP) and they took leveraged positions (borrowing money to make money, hoping to make enough money to pay back the borrowed money, and have a little extra for yourself).

It's not just about diversifying, your goal should be to diversify to minimize risk!!

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