Diversification is the bedrock of sound investing. Yet as it is practised today I suggest it is nothing more than an illusion. This is because while the rules of sound investing have not changed over the last 100 years, the design of the financial markets has. What does this mean?
The fiat financial system has become a system of dependencies. Because the overwhelming majority of financial products are derivatives whose value depends upon other assets held by a counter party, the components of the system - assets, banks, clearing houses, insurers and brokers - are similar to light bulbs wired in series: if one fails all fail. This was demonstrated during the 2008 Financial Crisis when a single bank, Lehman Brothers almost brought down the entire system.
This inter-dependence of the financial system’s components is the root cause of the illusion of diversification.
It can be argued that government will always be available to bail the system out. But will they? Historically governments have not always acted in the best interests of investors. Indeed the need for bailouts simply illustrates the design issues the fiat system faces that current portfolio diversification does nothing to address.
On the other hand true diversification can be found in distributed networks of independent nodes. The Internet is the classic example of this resilient design, as are the server farms of Google and Amazon. How can this distributed network structure be utilised by investors wanting to return to sound investing?
If a server in one of Google’s data centres fails, Google’s entire enterprise does not collapse.
The tasks Google’s servers perform are distributed across multiple units so that a single failure is not catastrophic. This is genuine diversification in practise and is similar to wiring light bulbs so that they are in parallel. If one bulb fails, the other bulbs remain on.
Genuine portfolio diversification has the same goal as Google – a robust design where the task of generating returns is not exposed to the risk of catastrophic failure. However now that the fiat financial system has shown itself to be fragile to just such a collapse any asset held by a portfolio that is part of the fiat system shares this systemic risk. This also means that no component of the fiat system added to a portfolio is going to diversify away from this risk.
The only way to emulate Google’s distributed design is to hold assets outside of the fiat system itself.
I suggest the current illusion of diversification can be dispelled and genuine diversification restored in two steps:
First, recognise that all fiat financial products are one system, separate bulbs in series. It does not matter if the assets are currency, bonds, ETF’s, large cap, emerging markets, options, volatility etc. All these assets are part of an inter-dependent whole. Failure of the fiat financial system, for whatever reason, can have catastrophic effects on the value of assets dependent upon it. Genuine diversification within this single system is not possible.
Second, re-constitute the portfolio with assets that are stand-alone systems of value, independent of other systems. In other words emulate Google, Amazon, and the Internet in building a distributed network of value where the failure of any component does not jeopardize the value of the entire portfolio.
The first step is the hardest because it is a question of perception. The fiat financial system is so large that it seems impossible that it is just one system. Passengers on the Titanic must have had a similar experience which was one reason why so few passengers were eager to climb into the (scarce) lifeboats when the ship struck ice. An investor or investment manager may have spent decades building a seemingly diversified portfolio. To accept that the assets held are in fact single facets of the same system – like bulbs in series – may be a very hard pill to swallow. In this case illusion becomes delusion with the resulting consequences for the portfolio.
The reconstitution of the portfolio is a practical task. When the criteria for inclusion becomes one of self-contained systems of value independent of other assets, the range of options are limited but clear.
Property, owned outright
Commodities including precious metals, physically held and owned outright
Outright ownership is required in order to preserve the independence of the asset from the fiat system. Physical ownership of commodities is required for the same reason. There is no reason not to include fiat-based assets, including fiat currencies, as long as it is recognised they collectively count as only one component of a diversified portfolio.
All asset classes except fiat-based assets can be held as multiples. For example holding physical gold and physical silver and physical platinum all increase the diversification of the portfolio. Each is an independent silo of value from others.
The same is true of property. Property can be residential and commercial. In the same way that Google has multiple server farms around the world, the independence of each property asset is increased by geographic distribution so that an earthquake in one city does not affect the value of properties located elsewhere.
The simple test to establish whether an asset is adding to the diversification of a portfolio is to ask if it has stand-alone value or if its value dependent upon the value of other assets.
Blockchain technology has increased the range of independent silos of value available. Digital currencies such as Bitcoin, Monero and Litecoin are user-generated systems of value. This value is secured on the currencies’ own distributed ledger, the blockchain that requires no external dependencies for that value to be maintained. As such, these cryptocurrencies can be treated as separate assets increasing a portfolio’s diversity.
The blockchain can also be used to create other financial products that are independent silos of value. Called Self-Managed Investments (SMI’s) the asset class issues digital tokens that track simulated investment strategies. The use of a simulated strategy keeps the asset independent of the fiat financial system. The first SMI is a long/short Bitcoin strategy called Bitcoin Enhanced. As SMI’s increase they have the potential in expand the range of investable assets available that re-create genuine diversification.
A server in a Google farm can be expected to fail. The same is true of assets within a genuinely diversified portfolio. Yet it is this very ability to fail and not destroy the portfolio that is the test of sound design. If the fiat system fails, how many assets in your portfolio would still be standing?