FINANCIAL DIVERSIFICATION RISK
Diversification is the only free lunch in finance.Harry M. Markovitz, the 1990 Nobel Prize winner in Economics
Diversification – not putting all eggs in one basket – is the most effective way of managing portfolio risks. The goal of diversification is to ensure that all of the portfolio asset classes are not equally exposed to the same key risks:
- Price Risk – assets that go up at the same time, tend to go down at the same time. Without effective diversification, portfolios can suffer irreparable losses.
- Liquidity Risk – when everyone is trying to sell at the same time, liquidity dries up and losses get magnified as securities cannot be sold. Loss of liquidity can have far-reaching consequences – inability to meet current obligations, forced liquidations, etc.
- Counterparty Risk – losses caused when banks, brokers, custodians or exchanges fail to perform as promised. e.g. In 2008, insolvency of several key institutions greatly magnified losses and exacerbated severity of the crisis.
- Geographic Risk – location-specific economic, legal or sovereign risks can trigger catastrophic losses in portfolios that are over-exposed to the affected region.
WEAKNESS OF FINANCIAL DIVERSIFICATION
If you are like most investors, it is likely that your portfolio is over-allocated to financial assets, which have become highly correlated and are exposed to the same key risks. Essentially, your “financial” eggs are in one basket – your portfolio depends on the over-leveraged financial institutions and your cash depends on the over-leveraged governments.
Throughout history, gold has been an ideal portable source of diversification and independent liquidity without counterparty risks. Physical gold is the most liquid non-financial asset and is more liquid than all of the financial assets during extreme conditions. This property of gold remains as valid today as it has been in the past.
- Price Risk – in the long term, gold price has no correlation to financial assets; in the short term, whenever confidence in financial assets, institutions and governments goes down, gold prices go up.
- Liquidity Risk – gold remains the most reliable liquidity source of last resort; it is universally accepted and liquid under all market conditions.
- Counterparty Risk – physical gold does not depend on financial institutions; it is no one’s liability and does not rely on anyone’s ability to perform as promised.
- Geographic Risk – physical gold is the only liquid non-financial asset that can be practically held in different jurisdictions without involving financial institutions.
Inclusion of uncorrelated assets, such as physical gold, in a diversified portfolio reduces risk and enhances performance over the long term.