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The Fallacy of The Diversified Portfolio

Given the current state of affairs in the investment markets – particularly that fundamentals have long ceased mattering and tweets move the markets instead – I think a frank discussion is called for.

It’s an article of faith amongst financial planners that one must diversify his or her portfolio; that their investments must be spread across several economic sectors: transportations, utilities, growth stocks, emerging markets, and so on. And, of course, there’s a certain reasonableness to it: Those market segments go up and down at differing times (or at least used to), and no one knows enough to pick precise winners and losers. And so, spreading the money out means that you’re less likely to be wiped out by a surprise move.

The problem is that this type of diversification, while fine so far as it goes, misses the proverbial elephant in the room. And that elephant is capable of rendering diversification moot… as in blowing through it like tissue paper.

And so I think this is important to point out. A lot of decent people are relying upon “diversification” to protect their retirement money. And maybe it will. Or, maybe it won’t.

The Core Issues

The deep problem is that people don’t question diversification because “everyone does it,” and “authority says so.” Those are just about the most dangerous phrases known to the human race. The emotional hook is that you’re insulated from blame by staying with the crowd. If you do something different, on the other hand, any error you make can be exploited against you forever. Needless to say, none of this makes for particularly good choices.

But, let’s get right to the point.

Diversified assets – the aforementioned asset classes – are not really diversified. Yes, you may own so much utility stock, so much in foreign bonds and so on, but all those assets are held in a single pot, controlled by others.

That is, 100% of the assets of the typical retiree are held on Wall Street. And they’re all in government registered accounts. Unless you specifically choose to jump through inconvenient hoops, you don’t precisely own the shares of stock you paid for; your broker owns them for you. That’s a complicated generalization, of course (these things are always complicated), but it’s also generally true.

So, your portfolio is diversified so fas as it goes, but it all sits in a single pot, controlled by the lords of Wall Street and their partners at government agencies.

The typical response to this is, “So what? They’ll never take our money!”

The purpose of that statement, however, is to drive away an unpleasant concept. Or, perhaps, to appeal to the gods. Of course governments seize assets, they do it all the time.

FDR seized nearly all the gold in America. He had to wait until everyone was really scared, of course, but he stole the gold, “compensated” its owners at a terrible exchange rate (which he raised once the payments were made), and did it all with impunity.

The bosses of Cyprus shut down all the banks in their country and seized a good portion of the money in all the country’s bank accounts, the government of Ireland swiped €6.5 billion from their National Pensions Reserve Fund, the French parliament took €36 billion from a reserve pension fund, Hungary took $13.5 billion from retirement accounts, Poland took one-third of future contributions to individual retirement accounts.

The IMF has produced papers proudly suggesting “financial repression” to fix economic problems. And back in August 2010, the US Departments of Labor and the Treasury held joint hearings, deciding how best they could take control of all assets in IRAs and 401(k) accounts.

So, yes, they can, and they do, and they keep blueprints for doing so in the future. That means that diversification is valid only until the next time the pot-holders to dig their hands into your assets. 

What Is To Be Done?

Understand, please, I don’t have any perfect solution to sell you. What I’d like is for people to understand that diversification, applied to the usual portfolio, can and will be rendered void when the lords of finance decide it should be. And at that time there will be very little you can do about it.

Those of you who are concerned about such thing can figure out what is best for you. And note, it will always be less convenient than walking the prescribed path. The smooth, easy and wide path is nearly always one that was built for your fleecing.

We all know the alternatives: Bitcoin, cash, gold, real property, investments in local businesses, and so on. These are alternative market segments, and using them creates an actual diversified portfolio.

So, do what you think is best, but be clear on the fact that all your “diversified” investments are held in the same pot, and that pot is under someone else’s control. When things get serious, the people who control that pot will use it as they see fit, not as you see fit.

Maybe that won’t happen for another decade or two. Maybe it will happen next year. Seeing the future is difficult. But seeing the fact that all your money rests in someone else’s hands isn’t too hard.

**

If you want a deeper understanding of these issues, see:

          FMP issue #7

          Parallel Society #4

          The Breaking Dawn

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