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Jan 14 (Reuters) – To diversify investments is to bet on, rather than against, human ingenuity.
Diversification is a bet on human ingenuity, but made in a humble way which wants to capture a fair share of ingenuity in aggregate rather than a huge share of advances in particular.
Investment guru Dylan Grice once said that investing in commodities was a bet against human ingenuity. His point, most recently illustrated by the plunge in the energy markets, was that investors were wrong to expect a real risk premium from an asset class whose prices should be expected to decline in real terms over the long term.
Human beings figure out a better way to create commodities more cheaply or to obtain more of them than previously thought possible, fracking being but one example. That caps price gains and makes it hard to profit over the longer term.
Better, under the circumstances, to try to capture the benefit of that ingenuity, usually by investing in equities, which give holders unlimited upside to benefit from a better, cheaper drilling apparatus, cell phone or mousetrap.
There are basically two approaches to this strategy: to be discerning, or to be humble.
THE WAY OF THE STOCK PICKER
The first way, historically far more popular and definitely far more fun, is to try to discern which technologies will displace which business models and then invest accordingly.
There is much to be said for this, after all.
Firstly if you get in early and correctly you can make a fortune. Figure out that America is going to want to drink individual cups of coffee made with little capsules (an idea I found hilarious at first) and you might be an early investor in Keurig, now part of Keurig Green Mountain, the wonder stock of the most recent decade. Everybody, well almost, has an uncle who almost bought McDonald’s at 30 cents in the 1960s.
This is also, besides potentially greatly enriching, a lot of fun. It is immensely satisfying to be the stock picker who figures out how the future is going to break. This makes us feel that, rather than simply being rentiers exchanging our capital for a return, that we too are innovators improving the lot of mankind with our capsule coffee. Scientists, almost.
I am convinced that much of the mysterious appeal of active fund management and its bad twin, hedge funds, is that they make the client feel clever.
The irony here is that though you may have decided that you want to bet on human ingenuity, as a stock or fund manager picker you’ve decided that the way to do that is to rely on the judgement of one person: you. You can use all the gate keepers you want, but ultimately you are choosing to delegate the technology picking to someone else. Why you might believe that you are well suited to make this choice, other than the fact that you happen to have assets, I cannot say.
THE WAY OF THE HUMBLE
The alternative is to accept that, on the evidence, people are good at innovating and that these innovations will increase output and living standards.
But just as ingenuity makes fortunes, so it destroys them, eating the lunch and profit margins of those businesses whose operating models are displaced.
A well-diversified portfolio is positioned to benefit from those innovations in aggregate, earning a modest but less volatile return. It isn’t necessary to work out that the Erie Canal will kill the businesses of some eastern farmers or millers, or that the railroads, less than a generation later, will do the same to the Erie Canal and some of its beneficiaries.
Given that the Internet is so revolutionary, the stock picking way is particularly tempting, but if the innovation is more ground breaking, more lunches are going to be eaten. WhatsApp looks like a revolution, and so it may be, but it is very hard to gauge both how sustainable and profitable it will be and whose profits it will eat. Better instead to take a modest premium from a more efficient, better connected world.
Diversification works two ways: giving you exposure to innovation while making sure you don’t get too badly hurt by its collateral damage.
That’s even before we consider the ways in which diversification, one of the only free lunches of the investment world, allows for better risk-adjusted returns.
Have faith in the future, but be humble enough to understand you have little specific idea what that means. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. – REUTERS
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