Why Investing in More Paper Assets is Not Diversifying

Published on 03. Sep, 2010 by Thomas Herold in Investing

Stock Certificate

You have likely talked with more than one financial adviser in your life time. One thing that you may not have realized when you compared the different ideas of these various investment advisers is that they are basically all recommending the same idea, just in slight variations and with different words.

The overwhelming majority of these investment professionals will claim that you should more or less divide your investments up between stocks, bonds, mutual funds, and cash instruments. They will call this diversifying your portfolio to reduce the risk. If you dig deeper though, you will discover that investing in more paper assets, such as stocks, bonds, and mutual funds, does not actually turn out to be truly diversifying your portfolio.

The Concept of Diversification Explained
When financial people tell you about diversification, they are discussing the ways to reduce your risk through investing in a range of different assets. You are supposed to benefit from this because well diversified portfolios actually contain a smaller amount of risk than those that are invested into only one type of investment or asset class. If you are at all a risk intolerant investor, then you will want to do at least some diversification. People who are especially fearful of risk and economic uncertainty will engage in a greater amount of diversification.

Examples of Mainstream Diversification
There is an age old adage that warns you against putting all of your proverbial eggs into only one basket. This is because if you drop the basket, then all of the eggs will likely break. By putting all of your eggs into separate baskets, then you will greatly reduce the risk of breaking, or losing, all of them, even though one or two could break and become lost.

An un-diversified type of portfolio would be one that contains only a single company’s stock. In case you do not know, this is extremely risky, since individual stocks can easily fall by as much as half in a single year. In the last several years, you have watched as blue chip financial company stocks fell all the way to even zero.

Financial experts will tell you that a portfolio comprised of twenty different stocks is far less likely to drop by fifty percent. This is particularly the case if you select all of these stocks from differing industries, types, and sizes of companies. An even better way for you to diversify, per mainstream financial advisers, is to purchase stocks that are based on companies headquartered in other countries. They might also suggest other types of investments like mutual funds, bonds, or money market funds. There is a problem with this advice as it pertains to diversifying your portfolio, since all of these different types of assets still have an underlying theme in common.

The Commonality of Paper Assets
The biggest problem with calling the purchasing of different kinds of stocks, bonds, mutual funds, treasury bills, and even money markets and certificates of deposit diversifying is that all of these different investments possess at least a few things in common. Remember the idea behind true diversification is to get into investments that are inherently different from one another. What makes all of these differing investment ideas ultimately similar?

It is the fact that they are all paper assets, whose value is also expressed in another paper asset, that of the dollar or a competing national currency. For example, a bond is simply a promise on paper from a company to repay money that you loaned to it to fund its ongoing operations or expansion plans. Treasury Bills are the same concept, with the borrower being the United States Federal Government, instead of a mere corporation.

Even certificates and money market funds are still paper based promises from banks and lending institutions to repay you money that you loan them so that they can make loans to still other people. A stock is even less secure than are these other types of investments, since stocks do not promise you anything. Ultimately, a share of a stock represents only the confidence held in a company by its investors. Confidence can be a very shaky and shifting concept in the end, easily destroyed by a rumor or bit of bad news.

The fact of the matter that you must grasp is that all of these paper based investments are more or less the same in the end, only different flavors of the same dessert. They are all based on merely promises or confidence in a company, bank, or even government. As such they can all be upended relatively quickly and easily, in particular in an unstable and evolving world like the one today.

The Common Underlying Currency of Paper Assets
You heard another commonality to all of these types of paper assets hinted at above. They are mostly all tied to the value of a single sovereign currency, like the United States dollar. No one is laughing anymore when the former head of the IMF and the financial editor of the London Times make repeated and persistent claims that the viability, stability, and even value of the U.S. dollar can not be taken for granted in the wake of the Great Recession.

In a very real sense, the United States has become a much larger version of Greece, where the amount of debt to government income level is no laughing matter. Is an actual run on the U.S. dollar in the cards, or even possible, as has been suggested by reputable individuals in the last months and year? The principal of diversification would tell you that if there is even a remote chance of a U.S. default on its sovereign debt, then you need to put a significant portion of your investment dollars into something that is not denominated in dollars.

This type of diversification would limit, or more realistically reduce, holdings of the most of cherished investments in America today. U.S. company stocks, bonds, mutual funds, money market funds, certificates of deposit, bank balances, and even Treasury bills would all fall into this category in the end. What would that leave investors like you who are eager to follow a true policy of diversification of your assets? The alternatives are explored in the following paragraphs.

What Are Non Paper Asset Classes?
You are probably wondering what types of investments are left for real diversification purposes at this point. If you are trying to diversify away from having all of your eggs in the U.S. Dollar basket, then you might look into foreign currencies or investments based in such foreign currencies as the British Pound, Eurozone Euro, Japanese Yen, or Swiss Franc. The problem with foreign currencies, and investments based in them, is that they are still ultimately only based on the faith and trust in each of those sovereign countries. Ultimately, they are still paper assets.

Non paper assets that make for excellent diversification include tangible investments that are based on physical assets. The two biggest types of these are real estate and precious metals. Real Estate is technically not based in any one country’s currency, regardless of where it is located. You can put your hands and feet on it. It is also permanent, and is not going anywhere.

The same is true of precious metals like gold, silver, and platinum. These commodities can be held in a safe deposit box in the form of coins or bars. They do not depend on any government or corporate entity’s promises, credit, or credibility whatsoever. Gold and silver also have the appeal of having been accepted as money and a viable form of payment for more than five thousand years. No matter how good your favorite blue chip company is, its odds of lasting for that amount of time are practically non-existent.