30 September 2022

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The power of diversification: We don't bet, we invest

Luigi Campopiano

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Volatility has recently returned, an essential characteristic of financial markets. But when it arrives, this characteristic always brings an emotional tension which, in the end, one is never quite ready to encounter. Given the persistence of inflation, risk of economic slowdown, new COVID variants, and previous pandemic lockdowns, there have been enough elements in play to affect the markets. 

And, with the return of volatility, a very important investment theme comes up again: diversification. Let's take two examples: 

• On Dec. 2, 2001, Enron, a U.S. energy giant, went bankrupt and became a powerhouse in the natural gas sector. Enron bought and founded companies worldwide — many in tax havens — and its managers earned superlative salaries thanks to hefty bonuses provided by the company. The company’s “accomplishments” were all fake, and included market manipulation, artificially inflated accounting activities and profits, hidden debts and losses in offshore companies. On Aug. 14, 2001, Chief Operating Officer Jeff Skilling announced his resignation. Subsequently, on Oct. 16, Enron declared a loss of $618 million and devalued its capital. A few weeks later, on Nov. 8, the company corrected itself on the profits declared the previous year, and on Dec. 2, 2001, Enron filed for bankruptcy protection in a New York court. 
• General Electric, for over a century was the emblem of American industrial power. The company created a vast array of products and was the representative par excellence of the so-called Old Economy. For over 100 years, GE was a leading company of the Dow Jones and the highest-ranked company in the world by capitalization from 1995 to 2005. GE exited the Dow Jones on June 26, 2018, and its bonds are considered to be at risk of default, also known as junk bonds. 

These events are not isolated. Many companies indexed in the S&P 500 have stocks performing 50% lower than their maximum value and some are performing as much as 70% lower or more. Many stocks that make up the Russell 3000 Index have underperformed the index itself; more than 40% of the shares have had losses of more than 70% from 1980 to date and have never recovered. Therefore, you are more likely to pick a single losing title than a winning one. Yet, this has not prevented the lists from achieving stellar performance in recent years. 

The moral is, as Jack Bogle said: "Don't try to find the needle in the haystack, buy the whole haystack.”  

In the financial markets, the winner is the person who diversifies their resources effectively, those who have patience and discipline, and those who do not get caught up in either euphoria or discouragement.