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Numbers Game - Diversification

Numbers Game - Diversification

| August 01, 2019

Welcome to Numbers Game! 

Numbers Game is my new blog here at Stone Bridge Asset Management.  I will be using this blog to provide updates on research we do. I love to pull apart perceived market edges and break them down by the numbers. I will use cutting edge software and some custom code as tools to analyze these tough problems. Don't worry, you won't have to understand any of that stuff.

For my first post I wanted to talk about Diversification.  If you are an experienced investor, then this is something you eat for breakfast, lunch and dinner. If you are a new investor, or just never found the time to learn about how your money can work for you, then here is a quick rundown.

TLDR: skip to the last graph

Diversification is described at length here.  It can get pretty complicated when you get into things like Modern Portfolio Theory.  I am going to try and keep this very straight forward.  Diversification is owning different assets that gain and lose value at different times.  Diversification helps us smooth out the wild ride that the markets can give us.  Diversification keeps us sane. 

It takes a special cold blooded individual to wake up to his life savings down 40% and shrug it off....  the average investor would lose their cool, and we want to avoid this as well as we can.... especially when that money is for something like a down payment on a house...or even worse, your retirement that you planned on starting next year.

Enough introduction...

Diversification in three simple graphs

We can do a great job diversifying your money by holding assets that go up in the long term and have a low correlation to each other.  The simple concept is to own assets that go up when the other assets you own go down or sideways... It doesn't always work perfectly, but its by far the most-used tool to keep your money safe.

Lets take a look at a few graphs to see this clearly....

This is the appreciation of a $100,000 investment in the S&P 500 index over a recent 1-year period:

Here is the 1 year appreciation of a $100,000 in long-term bonds over the same period:

As you can see, the sharp move up in bonds at the end of the year coincides with a corresponding sharp move down in equities.  This could be an indication that these two different assets have low or even negative correlation.  That is exactly what we want in a portfolio that is tailored to protect the money for a specific need.  Now lets look at splitting our money in half between these two holdings.

$50,000 in bonds and $50,000 in equities over the same 1-year period:

The Big Take Away!

As you can see, diversification is a very simple concept.  We mix assets to smooth out the massive swings in the market.  This is just one example of many different ways to diversify. If your invested money has a specific use in the future, then you should consider diversification as the absolute front-line defense against large losses.  It's really just a numbers game that we play to protect your money. 

I hope this was helpful, and if you have any questions about how to implement this yourself, then please reach out.

Joseph Davis

Trading and Research