The Wholly-Terrifying Risk of Non-Diversifiable Assets

Most of the ways in which we store money are diversifiable.

For example, if you store some money in the stock market, you can own a bunch of different stocks. And these days you can even own a single investment which represents, to a very close level of approximation, proportionate ownership of each and every stock in the U.S.

Today a single share of that investment would have cost you about $57.

Think of it: for $57, plus a commission of, say, $7, you could have an ownership interest in pretty much the entire American stock market. Sixty-four bucks and you own the whole shebang.

Now that's diversification: for $64 you can have an asset that is precisely as diversified as the $15 trillion U.S. stock market is diversified.

So even if something went drastically wrong with a single stock -- take, oh, I don't know . . . BP for instance, which, in a just-deserts sort of way, has lost $100 billion of its $200 billion market value since April 20th, when it, in an effort to spend $10 million less on safety measures for an especially deep well in The Gulf of Mexico, blew up a major portion of the Gulf, for an eye-opening 10,000-fold swing from money-saved to corporate-valuation-lost -- the problem with the stock still wouldn't have much impact on the value of your $57 share. That's because your $57 share reflects the entire stock market, full of thousands of stocks, so that BP represents, all-told, less than 1% of your $57 investment (the arithmetic is that the $100 billion which BP's value has fallen is two-thirds of a percent of the $15 trillion U.S. stock market).

So, all things being equal, the 50% downdraft on BP's stock would impact your $57 investment by less than 1%, or about four dimes-worth.

That's a hit you can afford to take, and that's what diverisification does for you: it translates the 50% loss suffered by BP shareholders into a 0.5% loss for you and your shares.

And, remember: before the debacle BP was among the Top 20 most valuable companies in the world, so its fall has had a far greater impact on the overall stock market than most downdrafted stocks would, so all but two or three handfuls of stocks out there, if downdrafted, would hurt your $57 investment a whole lot less.

And for those of you wondering about thinking that all we're talking about in here is idiosyncratic risk, and we're ignoring market risk, you are right: market risk is a topic for another day.

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More scarily, though, there are also ways to store your money that pretty much are non-diversifiable.

For most, real estate is the ultimate non-diversifiable asset. Because the reality is that most of us will never own more than one piece of real estate at a time. And that means that if, say, your house is in Guatemala City and it falls into a sinkhole, and if for some reason you do not have it insured against that risk, then your non-diversified risk has come home to roost, big-time. Ouch.

Or more presently, it means that, if you bought your house three years ago for 10% down, and if you find yourself now having to sell it because your job is taking you out of state, or if you lost your job and simply can't any longer afford the house , then your non-diversified risk has also come home to roost, also big-time, and also ouch.

And if you had to sell now, you would probably have to put cash into the escrow to the tune of, say, two of the downpayments you put up when you bought the house. Imagine that: putting 20% down to sell the house. Ouch.

Here's the arithmetic on where that 20% came from: figure that (a) the house cost $1 million, and that (b) the house has depreciated 25% ($250k), and that (c) you have an interest-only mortgage for 90% of the purchase price, so that (d) you owe the bank $900k, and also assume that (e) you will pay a 5% real estate commission for selling the house ($50k). In that case, you need to put $200k into escrow to sell the house, consisting of $150k to pay the bank its $900k (because you sold the house for only $750k), and another $50k to pay your broker (5% of $1 million.

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So how can a person be financially smart in the face of non-diversifiable assets like real estate?

It would be nice if we could buy derivatives that hedged the risk (i.e., you buy an investment which, theoretically, will increase in value if your house loses value, and vice versa), but all attempts at that thus far have failed, what with the DMM/UMM up/down housing twins busting at the end of last year.

I'm sorry to say, then, that, to date, the definition provides the answer: if the asset is non-diversifiable , then there's not much you can do to diversify the risk emanating from the asset, and that means that there's just not all that much you can do to smarten up the decision in terms of diversification. And that's that.

True, you can also do your best to make sure that you're not buying at the wrong time.

How to do that?

Well, there is no surefire way to do that. There just isn't. It hurts me to throw my hands up in the air and shrug, but that's the truth, and knowing that something is out of your control can be, in a way, freeing, and it definitely helps you be aware of what the risks are.

Yes, you can look at rent vs. buy charts and price trend charts, and, yes, you can call in the best economists and real estate agents, etc., but at the end of the day, I'm afraid, this is one of those situations in which you just have to hold your nose and dive into the pool, all the while praying to whatever it is to which you pray, and otherwise trying to increase your luck and alter an outcome which, sad to say, is subject to a terrifyingly non-diversifiable risk.

Instead, all you can rely on is luck: when it comes to non-diversifiable assets, you just have to be stone cold lucky.

Good luck then!

And, 'til Monday, here's to your financial health and may it continuously improve,


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The Life-Simplifying Beauty of Never-Need-to-Sell Investments

Most everyone wants less complexity in their lives.

Modern life, the thinking goes, is crazy-hectic, and there is never enough time to do things, so anything that adds to the crazy-hectic that isn't also great fun or otherwise rewarding must be jettisoned, and jettisoned as soon as possible.

As a result, The Simplicity Industry is out in full force.

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Simplicity is not one of the hallmark's of most people's s financial life. There are bills to pay, money to earn, choices to make, etc. And then there are taxes, one of the most complex of all areas of human endeavoring. And investing. And insurance. And estate planning. Etc.

Yearning for simplicity, though, many people force, in square-peg/round-hole fashion, simplicity onto their financial lives by . . . simply ignoring it. In the moment that does, in fact, effect some level of simplification, but over time it also tends to complicate, because a financial life, left to fend for itself, often entropies itself all the way out to ill financial health, the primary symptom of which is credit card debt.

So a person's financial life needs tending -- not a lot, but some.

The question, then, becomes, How can I involve myself in an arena full of complexity and not in turn get complexified?

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When it comes to the simplicity/complexity spectrum, investing is a great area to look at because investing is susceptible to becoming very complicated while it can also be designed to be quite simple.

Ironically, having a money manager often does not simplify things, what with the MM calling up and asking you to make decisions about which you know nothing, and what with you always wondering if the MM is doing a good job, and what with you always knowing that the MM is getting paid, via auto-ding, regardless of whether he or she does well for you, and regardless of whether he or she has even lifted a finger for you to earn it, etc.

So imagine that your MM calls you up and says something along the lines of, I want to sell your HP stock because I think it's had a good long run and is now over-bought, plus earnings are coming out next week and I think The Street's estimates are too high and the medium-term outlook too sanguine, while IBM looks good as a replacement because I think it's overdue for a run and because the Chinese are doing a lot of business with Armonk. Blah blah blah.

So what'ch'ya gonna say?

Most people say something along the lines of, Well, if you think so, go ahead, but their internal dialogue is more along the lines of, How in the world am I supposed to know if this is a good idea or not?

So, yes, having a money manager in your life means never having to directly manage your money, but, yes again, it also means having to manage a complex relationship involving a whole lot of your money.

And that extra layer can really be complicating.

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But wouldn't it be even more complicated to manage your own money?

Wall Street would have you think so. It's buttered bread is riding on its ability to make sure that you always think that way.

But beginning as a trickle 20 years ago and gaining momentum ever since -- with the rise of Schwab (still going strong, but often scoundrelly towards its customers), E*Trade (which, ten years ago and quite unfortunately, became more East Coast bank than West Coast tech company, and then proceeded to 95% kill itself by writing bad mortgages) and TD Ameritrade (with its Toronto Dominion Bank backing, now having amply proved itself to be a very capable and very real survivor), and all the other companies that have helped to make self-directed investing inexpensive, easy and mainstream -- that emperor has been decisively shown to be less and less clothed until, today, it is clear that the emperor is butt-naked.

Today, then, it's possible for you to be your own money manager and to be good at it, and for the whole thing to be incredibly simple and empowering -- and not a time-sponge. Yay.

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Now the full set of details about hows to be your own MM are beyond the scope of this piece. For this piece we'll just take a look at one small part of the self-directed investing pie.

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The saying breaking up is hard to do is true for investing as well as for loving, because, while buying an investment is relatively easy -- fun, even -- the hard part of investing is figuring out when to sell.

If an investment you bought goes up, what should you do? Should you sell it? That would bring you some new money. But maybe if you wait it could go up more and then you could get even more new money, right? So what to do?

And if it goes down, should you sell before it goes down more? Or should you hold on because it's just bound to come back?

Of such things is torn-out-hair made.

So selling is the hard part.

But what if you buy something that is designed to never be sold?

Hmmm . . . .

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If you serve as your own MM, you still have to make buy and sell decisions, but they needn't be like the ones described above. That's because, instead of buying stock in HP and IBM and the like, or Treasury bonds and muni bonds and the like, you can buy index investments.

Index investments represent broad cross sections of chunks of the investing world out there. So you could, for instance, buy an index investment that represents pro-rata ownership of every stock sold in America -- every last one. Another index investment might represent pro-rata ownership of every stock sold outside of America. Another could represent pro-rata ownership of every bond in America. Etc.

And the beauty of owning investments like these is that you need never sell them -- which means that you need never deal with the hard part of investing -- and that's a major simplification of your financial life right there.

Sure, you would sell them as you needed to raise cash in retirement to float your boat, and you would still need to rebalance (both topics for another day), but those sale decisions are based on your needs and are internal to you, rather than being based on thoughts about whether a given, highly idiosyncratic investment is no longer a good investment -- thoughts concerning something in the external world out there, over which you have no control and as to which you have no especially great information upon which to base your decision.

So, in general, index investments can be core, long-term-hold investments that you needn't think much about, if at all, while you own them. And then when the time comes for you to start switching them into something else (cash, for instance), your sell decision will be much easier than if you were trying to guess when to sell HP or IBM or a muni bond.

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This, then, is the starting point for what I call Rip Van Winkled money -- money that you put to sleep for twenty or more years, during which time you, just as Rip did to avoid an unhappy home life, can go to sleep and never pay much mind to what is going on in the meantime with your RVW'ed money-stored.

And, to paraphrase Herbert Morrison announcing the Hindenburg going down,

Oh, the simplicity of it all!

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'Til tomorrow, then, here's to your financial health, and may it continuously improve.

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