When people think of “diversification,” they usually focus on asset allocation. I have money in the stock market, some in bonds, and also real estate. OK, my assets are spread around, so I’m safe. End of story.
But wait. You’re probably a lot less diversified than you think – in terms of asset allocation, and in another, even more important, way that I’ll explain in a moment.
First, the correlations between different financial assets are higher than most investors realise, as shown in the table below. For example, the Singapore stock market and the MSCI Asia Ex Japan have a correlation of 0.88. And geographical diversification doesn’t help much.
This leads to what I like to call the egg truck problem. You might put your eggs in different baskets. But in a big financial correction (or even a small one), the egg truck that’s carrying all your different egg baskets crashes. True correlation involves different egg trucks carrying your egg baskets – because a high correlation between assets is dangerous. (Having some gold in your portfolio is one of the best ways to address this issue, as I’ve written here. Gold is some of the best insurance that you can buy.
Why you’re probably not as diversified as you think you are
And beyond your investible assets, you’re probably not as diversified as you might imagine – because you’re probably not factoring in your “personal equity”.
I’m not referring to how much you own of a company, which is the usual meaning of this term. I’m talking about a much more broad definition of your assets – financial and personal and professional experience and prospects and earnings power.
To explain this, let me tell you about my friend Andrei. He learned a hard lesson about diversifying his “personal equity”.
Andrei was my junior analyst at the bank where we worked in Moscow in 2007. He had gone to a Russian university, and got a job in finance making good money during the pre-crisis boom times.
Andrei had some savings in Russian rubles at a local bank, and a mortgage on a flat downtown. He felt like an investment genius because his speculations in Russia’s booming stock market were minting money, and the ruble was rising.
Then the global financial crisis hit in 2008-2009. The world economy fell ill, and commodities-reliant Russia caught pneumonia. The country’s stock market fell 80 percent, and the economy contracted 9 percent, more than any other big economy in the world.
It didn’t take long for Andrei’s dominos to fall. He lost his job, as the bank we worked for wobbled on the edge of bankruptcy. The ruble collapsed, and the value of Andrei’s savings fell by half in real terms. Worse, the bank that held his cash “froze,” and Andrei couldn’t get his money out anyway. He fell behind on his mortgage. The value of his stock portfolio evaporated.
And since he only had a Russian passport, and spoke only Russian (with spotty English), Andrei couldn’t easily go anywhere else. And all he knew was finance – and there were more out-of-work finance professionals than there were holes in the road.
Andrei was the opposite of diversified. His professional and personal “equity” were all in the same basket: Russia. And when things went bad in Russia, Andrei’s personal equity evaporated – not only his current assets, but also his future.
Equity is what’s left after you add up the value of everything you own, like stocks and stamp collections and your flat. Then you subtract what you owe (on your mortgage or to the taxman or your ex-spouse, for example). What’s left is your net worth, or your equity.
“Personal equity” diversification
But most people ignore what I call “personal equity” when they’re thinking about diversification. Personal equity is more than what you own now – it’s about how you’re going to build your equity in the future. As my Russian friend Andrei found, not diversifying your personal equity can spell financial disaster.
Your money is only part of the story. The rest of the picture is about where you’ll be earning your living – adding to your savings – in coming years. Where is your paycheck coming from? What other sources of income do you have? That’s how you can get a sense of how diversified you really are.
Most people work in the same country where they have almost all of their assets. And even if you do hold some foreign shares or own real estate in another country… when you factor in where you’ll be earning money in the future, you’re probably a lot less diversified than you think.
If you’re going to be living in the same place for a long time, maybe forever, it probably makes sense to have a lot of your personal equity in that country. If you live and work in Thailand, what’s wrong with holding all of your assets in (say) Thai stocks, bonds, and baht?
There’s not necessarily anything bad about that. After all, it’s what most people do. But it might be riskier than you think.
What if the banking sector goes bust… your home currency massively devalues… the real estate market crashes… or the government starts searching for ways to plug a massive budget deficit, and your assets are all in that country? They’re just cherries for the picking.
My friend Andrei had one other big asset in his personal equity: Time. He went back to school, learned some English, and reinvented himself as a consultant. Now he’s living in London.
Andrei learned the hard way that he was nowhere near as diversified as he thought he was. Stocks, bonds, real estate and other financial assets are just one piece of the equation. Your “personal equity” is much bigger than that. And in the long run, it matters a lot more.
What does this mean for you? Think of diversification in a way that encompasses other countries and currencies… and skills and geographies. If your strategy towards investment – in financial assets as well as your personal equity – is completely diversified, you’ll be a lot better off in the long run.