Shortly before the financial crisis rocked the world economy in 2007/8, optimism amongst US policymakers was high and widespread.
On June 2nd 2005, only 3 years before many of the worlds largest financial institutions were on the brink of insolvency, Christopher Cox stood in a room full of reporters. Cox was the new Chairman of the Securities and Exchange Commission or the SEC, under the Bush administration. The role of the organisation was to protect investors from foul play in financial markets, ensuring a level playing field between customers and asset management firms.
After his public introduction from President Bush, Cox took to the podium to set out the responsibilities of his new role and the state of the economy. He praised the financial sectors contribution to US economic growth, saying “In this amazing world of instant global communications, the free and efficient movement of capital is helping to create the greatest prosperity in human history.”
Little did he know what was around the corner, but of course, no one really knew what was coming. Even the Chairman of the Federal Reserve, Ben Bernanke said in January 2008, “The Federal Reserve is not currently forecasting a recession.” It turned out that the SEC and other bodies that were supposed to protect the interests of investors, had stood by while banks were taking greater and greater risks and engaging in dangerous behaviour. Banks were taking enormous risks in the derivatives market, trading highly complex financial instruments like CDOs (collateralised debt obligations) and MBS (mortgage backed securities). Banks were also highly leveraged, which meant they were borrowing huge sums in order to take part in this kind of activity. There was a get-rich-quick culture pervading the financial sector. In this era of widespread irresponsibility on the part of some of the most famous investment management firms in the world, selling more toxic products to unsuspecting investors meant bigger bonuses. As such, it led to the eventual meltdown.
The damage was more serious that anyone could have imagined. In those years, investors lost life savings, while millions of ordinary citizens became homeless and unemployed, in a financial slump that left no country on the planet unaffected.
Why am I talking about the crisis? Well, it’s merely an example to highlight potential risks and why you should hedge against them as much as possible. Risk is a major factor to consider when choosing what to invest in. Financial markets are entities which are linked to human sentiment. Even if the crowd and the talking heads think they are ‘right’ about the way a price, or a company, or interest rates are heading, markets are still, (in the words of billionaire investor George Soros) “inherently unstable”. Due to this instability, it makes sense to hedge your bets and spread your risk across different sectors, asset classes and types of markets when investing.
Financial markets are all interconnected. Even the largest blue chip stocks which we hear about every day are not immune to external forces which can weaken their fundamentals. Geopolitical circumstances out of your control can cause huge sell offs in a single day, putting your portfolio at risk. Perhaps a war breaks out in Asia and suddenly every stock index from Tokyo to Shanghai loses a ton of its value, for example. Even shiny new instruments like cryptocurrencies which are currently all the rage have been known to lose hundreds of dollars off their value in a single trading day. Yes, it would be nice if markets were predictable and human behaviour was also less impulsive, but this sadly is not the case.
How do I diversify?
Diversification is a form of risk management, but it is also a tool you can use to make money as well.
The idea behind diversifying a portfolio is that investors will be less affected by an event that has a strong impact on a particular industry, company or type of investment. Not putting all of your eggs in one basket is another way of thinking about it.
By ensuring you invest in a multitude of sectors and asset classes, you can be more shielded from external shocks to the market (like geopolitical circumstances, economic downturns and the like).
By keeping investments split into different asset classes, (by choosing varying position sizes in different sectors) investors can become fairly well hedged incase of any destabilising news which will cause prices to fall.
Even if the flavour of the month is a bluechip giant in the S&P500 and every analyst seems to be singing it’s praises, going all in on the stock or similar companies within the same sector can be a foolish decision. Trends come and go frequently. Sectors lose steam, indexes that were once riding all time highs lose their edge. We saw recently how a political crisis in Brazil which engulfed the country’s leader Michel Temer, ignited a huge selloff in Brazilian stock markets. The key Bovespa index saw it’s biggest fall in almost 9 years on the same day corruption charges surfaced.
It is not possible to do away with all risk, but by hedging your positions and keeping your risk spread across different kinds of instruments, you can keep protect yourself against large-scale losses and maintain your well earned gains.