You need fish. For the sake of illustration, let’s pretend you own a seafood restaurant and you need fresh fish every single day. In a sense, your business - your very livelihood - depends on the fisherman’s ability to catch fish daily in the varieties and quantities you need.
Now, nothing can be easier or cheaper than using just one fisherman. He ventures out each morning, returns around noon, and you meet him at the dock when he arrives. The fish are fresh and his schedule predictable. Besides that, Mr. Fisherman is delighted to sign a contract giving you preferred pricing. (For more, see: The Importance of Diversification.)
There’s only one small catch (you’ve already spotted it, haven’t you?). Sometimes the fish don’t bite. Mr. Fisherman meets you at the dock with an empty creel. Frantically, you race from boat to boat to boat seeking tonight’s red snapper. Too late, you discover that today’s bay is empty. The fish moved on during the night. Perhaps tomorrow will be better.
Tomorrow? What about today? There’s an anniversary party and a business meeting, lunch customers already waiting well, you get the picture. Tomorrow is too late, and crisis is a bad time to learn anything.
Looking back, one lesson is very clear. You can’t rely on one fisherman or just one bay. Instead, you need several (maybe dozens) of fisherman working with a variety of bays, baits and boats. Good fisherman, all, but each subject to the ocean’s movement and whims. When one fails, another succeeds. Through variety, you develop a reliable source of fish for your restaurant. And, a safety net for your livelihood.
Mutual Funds, Investment Managers and Fishermen
Mutual funds and investment managers are a lot like those fishermen. By design, they use certain techniques in certain waters. They are experts at catching fish, but only when fish in their part of the bay are biting. Otherwise, they troll for the day when fish return. That’s their job and any of them do it rather well.
A lot of investors stumble over this idea. They can’t understand why you’d stick with an investment or fund without stellar recent performance. They see international investments or small company stocks, for instance, and assume you should ditch them from the portfolio. Lately, we’ve heard rumblings about bonds and bond funds.
But you shouldn’t blame the fisherman when fish aren’t biting. That’s like blaming the farmer for bad weather or an airline pilot for turbulence. Most of us do the best we can with the circumstances we encounter. Some are good, others are bad. But that doesn’t make us good or bad. In investing, circumstances tend to cycle between good and bad, but the goods tend to outweigh the bads over time.
The Safety Diversification Offers
Diversification is important because it offers an element of safety to portfolios and that is why we do it. Significantly, we also know that Modern Portfolio Theory bolsters that concept by showing how mindful diversification increases returns and reduces volatility (risk). In other words, variety adds both safety and quality to investment portfolios.
All those different investments provide insurance. The past year or years haven’t always been good to each of them, but their day will come. And when it does, some other investment sector will likely fall off. In this sense, diversification protects us from a fishless day. Something is biting somewhere and we want to assure that we are there for it. (For more, see: Diversification: Protecting Portfolios from Mass Destruction.)