Free lunch investing: Top 20 myths part 4

Blog first appeared in DanCollinsReport on Sept. 2, 2013

Jackass Investing: Don’t do it. Profit from it”, has been a Kindle best seller since its release in mid-2011. Written by 30 year hedge fund veteran Mike Dever, the ground-breaking and controversial book introduces several innovative concepts – proven over decades of trading – including the replacement of “asset classes” with “return drivers” and a risk-based portfolio allocation method to replace conventional portfolio diversification.

In it Mr. Dever exposes 20 common investment myths and we are presenting them here with an explanation of each. In his first installment Dever concentrated on general investment myths that have somehow become etched in stone in traditional investment circles. The second installment included myths that have helped to keep trend following strategies on the margin; myths 11 through 15 touched on some general biases against futures markets and myths 16-20 explains what true diversification is and shares a "Free Lunch" strategy.

Myth #16: Allocate a Small Amount to Foreign Stocks

I use a survey of football fans to show that, sadly, institutional investors are no less immune to emotional decision-making than is your rapid NFL fan. And individual investors make the same mistakes in concentrating their portfolio in their home countries. This is just another of the many examples in the book regarding the irrationality of people’s “investment” decisions. (I put the term “investments” in quotes because what most people do with their money I consider gambling, not investing. My definition of gambling – and “Jackass Investing” – is that they take unnecessary risks with their money.)

Myth #17: Lower Risk by Diversifying Across Asset Classes

“Asset Classes” are an archaic artifact of our investing past. They are intentionally self-limiting and their use exposes people to unnecessary risks. Perhaps the most significant single financial innovation I present in the book is to replace asset classes with “Return Drivers.” A truly diversified portfolio, one that is diversified across return drivers rather than highly-related asset classes, can provide investors with the potential for a “Free Lunch;” a portfolio that earns both greater returns and less risk than a conventionally-diversified “Poor-folio.”

Myth #18: Diversification Failed in the 2008 Financial Crisis

Portfolio diversification didn’t fail during the financial crisis of 2008. Conventional wisdom failed. People had been instructed to create Poor-folios – not truly diversified portfolios – and gamble their money on a single set of return drivers. People failed to diversify. In this chapter I show how trading strategies based on disparate return drivers were able to create true portfolio diversification and avoid the sharp losses suffered by so many.

Myth #19: Too Much Diversification Lowers Returns

Diversification is the one true “Free Lunch” of investing. Of course, by definition, a diversified portfolio will underperform the best performing constituents of a portfolio. And if you can consistently determine, in advance, which constituents will outperform all others, more power to you – concentrate your portfolio in those constituents as you’ve discovered the crystal ball of investing. But for the rest of us mere mortals, portfolio diversification is the financial equivalent of magic. It can produce both higher returns and lower risk. I show how two losing strategies can combine to produce a profit. Now that is magic!

Myth #20: There is No Free Lunch

This is perhaps the most insidious of investing myths; the belief that the only way to earn higher returns is to take on greater risk. This myth is true if you insist on following conventional investment wisdom; if you limit your options and spread your money across asset classes. But it is patently untrue if you create a truly diversified portfolio that is balanced across multiple return drivers. Bottom line is there is a free lunch. You can achieve both greater returns and less risk. But you must demolish the poor-folio based on asset classes with a truly diversified portfolio balanced across return drivers. I bust this myth by showing specific examples of truly diversified portfolios that outperform conventionally-diversified portfolios by more than 3 to 1.

 

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