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 risk. Because the reality is that most of us will never own more than one piece of realty 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,