Part VI · Chapter 16 · Keep · lesson 2
Diversification in practice
12 min
Builds on Diversification stops working when you need it
Part VI · Chapter 16 · Keep · lesson 2
12 min
Builds on Diversification stops working when you need it
Someone holds eleven different things. They are pleased about this, and by the usual definition they are diversified.
All eleven are shares. All eleven are listed in one country. All eleven are held at one institution. And the income paying for the whole arrangement comes from one employer in one of the same industries.
That is one position, described eleven times.
Diversification has four dimensions and almost everybody works on one of them.
Across assets — different things, whose prices are driven by different causes. Across income sources — different reasons money arrives, which fail for different reasons. Across institutions — different places holding it, so that one failing does not reach all of it. Across countries — different currencies, legal systems and political weather.
The question in every dimension is the same: what single event could reach all of it at once.
Holding many things only helps to the extent that the things move for different reasons. Correlation, not count.
Track 7 made the awkward observation: correlations rise in a crash, because a crash is largely a synchronised demand for cash, and a synchronised demand for cash does not care what the assets were. The diversification that mattered on the calm days weakens on the day it was needed.
That does not make it useless. It changes what it is for. Spreading across assets protects very well against something specific going wrong — a business, a sector, a building, a fraud at one company — and considerably less well against a general fall. Those are different risks, and the first one is more common.
Predict
For most households the largest asset is future earnings and it is entirely undiversified. One employer, one skill, one industry, one city.
This dimension is harder to work on than the others, and the moves available are real: a second income in the household from an unrelated field, a side activity that could scale if it had to, a skill kept current in a second area, or work that is portable between employers and between countries.
None of these are quick. All of them are worth more than another few holdings added to a portfolio that is already spread across thirty.
The test is the same as everywhere else. Name the event. A downturn in one industry, a health event affecting one person, a regulatory change in one profession — for each, count how many income sources survive it.
Where the money is held is a separate risk from what it is invested in, and it gets almost no attention because institutional failure is rare.
Rare and severe is the combination the risk inventory flagged. The mechanism is straightforward: an institution that fails, freezes, is hacked, or merely locks an account during an investigation removes access to everything held there, often for a period nobody will specify in advance.
The defence is boring and effective: more than one institution, with enough at the second one to keep living while the first is unavailable. Note that the severity here is often about access rather than loss — the money may be entirely safe and entirely unreachable for six weeks, which is enough to force every decision this track is trying to avoid.
Not the same thing
Adding holdings whose outcomes are driven by different causes, so that one event cannot reach all of them.
Adding holdings that behave much like the ones you already have, in the belief that more names is more safety.
Which is which? Put each one on a side.
Adding a fourth fund with heavy overlap with the first three
Moving a year of spending to a second institution
One partner retraining into an unrelated field over three years
Splitting a holding across nine companies in the same sector
The fourth dimension protects against events that reach an entire country: a currency losing value against everything, a legal change affecting property or ownership, a banking system under strain, a government that stops behaving predictably.
For most people most of the time, this dimension is over-worried and under-acted on, in that order. It is also the most expensive to work on: currency conversion, unfamiliar rules, reporting obligations, and the real possibility of making a worse decision in a system you do not understand.
The proportionate version is usually modest — holding assets whose value is not entirely tied to one country's economy, and not holding every currency exposure in the same one — rather than the elaborate arrangements the topic tends to attract.
Check