On Diversification

Of late there has been a general loss of faith in the institutions that guide us, few more important or
notable than the role of the U.S. Federal Reserve. Slow to realize the problem, and now following
potentially dangerous policies, the Fed has contributed to a landscape that is barely recognizable from
those of just a decade or two ago. It is in John Maynard Keynes name that the inflationary game has
begun, first in Washington, now the world over, as countries scramble to weaken their currency in an
effort to remain competitive. Likewise, the second step is a Keynes derivative, that being to use inflation
to force corporations and individuals to put cash to work as the value of money is perceived as
perishable. In the face of such drastic action, there will be violent swings before we arrive at any sort of
a new normal.
That considered, there is no time like the present to review what went wrong and also for making
strategic adjustments, if one is up to the challenge. Now, a key component of the analysis must consider
the past and present, but it should be stated that an exceptional investment thesis is forward looking.
That means no one is ever right all the time. Success requires constant vigilance and readjustment with
the then prevailing conditions. The nature of cycles and fads are such that past winners often end up in
todays junk heap.
With recent market challenges, and the ratcheting up of fear, I am prone to review the concepts of the
market masters. Over my years of investing, I have found the value principles of Warren Buffet and Ben
Graham before him to be the most sound in investing in normal markets - solid fundamentals providing
a real basis for knowledge based investing.
Now while there may be many different investment styles, in order to be useful to investors, they must
be considered within personal constraints. Key among these considerations are the related concepts of
asset allocation and diversification. Few are unaware that Asset Allocation is simply making sure you
have the right mix of assets: stocks, bonds, commodities, real estate and cash. Likewise, this mix is
known to be largely personal, depending on your goals, timing and risk preference. Diversification is a
much discussed and related strategy which seeks to reduce the risk of being too exposed to any one
category, while ensuring your investments in each category arent concentrated in a way that might
undo the primary goal of the Asset Allocation process!
Now while Keynes name has been sullied, it is important to note that the man had a lot of great ideas.
And one was on diversification. In short, while Keynes may have unwittingly contributed to the loose
financial policy which may one day bring an inflationary catastrophe to our shores, he did go on to run a
very successful investment practice. He, too, was unafraid to adjust his outlook as things changed, and
held a fluid attitude about economic theories, noting that As time goes on, I get more and more
convinced that the right method of investment is to put fairly large sums into enterprises which one
thinks one knows something about and in the management of which one thoroughly believes. It is a
mistake to think one limits one's risk by spreading too much between enterprises about which one knows
little and has no reason for special confidence.

The argument was accentuated by the theories of concentration and risk of William Poundstone, who
had his share of genius allocated to him. His argument was that one might hold something back from
the market, but that the real gains were made when one saw an opportunity, and went all in. Warren
Buffet too, subscribes to the benefits of concentration, and the resulting reduced risk due to the extra
care and attention we pay to an investment if we are to invest a relatively large part of our portfolio.
Most investors are aware that they do not have the skills or knowledge of a Keynes or Buffett and so, for
obvious reasons, lack some of the confidence required to operate a concentrated portfolio.
We are indeed entering a new normal. The global nature of enterprise now means much of localized
controls and regulation cease to have teeth. Past financial interactions have changed, or ceased to exist.
Note the more recent episodes as the 2010 flash crash, bond and equity prices moving in unison, (insert
further examples here). Trillions of dollars of leverage now wash through the system and often far
outdistance the real assets of our economies. Japanese day traders obtain obscene leverage which may,
in the future, create unforeseen consequences for real commodities and instruments. While Chairman
Bernanke feels economic conditions are improving, he seems to be the only one. While few believe
rates can go lower, it is an unspoken truth that the U.S. Fed can continue along the inflationary road for
some time, having once kept long rates below 3% for 22 years, while Japan has been doing so since
1995!
Long one of the luminaries on the global investment scene, Marc Faber has recently described a loss of
faith in the markets, something reflected by the diminishing interest of individual investors in the
markets. In such times, the need for diversification increase. Faber recently noted that I have
repeatedly emphasized the importance of diversification over a range of different asset classes (real
estate, bonds, equities, precious metals, etc.). I think investors should also diversify their equity
exposure by investing according to different investment styles, and whereby they should select
managers that have a strict investment discipline and which can afford to be patient because their
funds shareholders are less interested in short-term speculative capital gains than in long term
sustainable performance.
Faber has seen his share of financial crises, so his views are especially pertinent. Even if one thinks an
outcome is certain, the wise allocate their capital to account for possible unforeseen consequences. No
one knows what might happen in the future, a case in point: for those pondering a possible banking
crisis pre 2008, the idea of a bailout of the too big to fail was unknown.
With risks increasing globally, we see that the key to any asset allocation is a disciplined strategy which
features diversification into relatively uncorrelated asset classes. On this subject, I continue to believe
that gold and its producers will provide crucial protection throughout the ongoing global liquidity effort
and world-wide currency debasement process. Commentary continues to suggest that gold's safe haven
appeal has been tarnished in recent weeks. Similar commentary was seen in the aftermath of price falls
in 2007, 2008, 2009, 2010, 2011, and now in 2013.
That said, the case for deflation is becoming increasingly evident. While QE benefits large financial
institutions, the effect on the actual economy and employment has been dismal. There will continue to

be periods wherein the stock market may fall due to fears that it will lose the support of ultra-low, longterm interest rates, and the added consumer spending resulting from a nascent housing bubble.
The bond market, too, has been showing signs of life in the form of higher and more realistic long term
rates, as participants sense that its biggest customer will be exiting the market. The sell-off in
government and corporate debt pushed yields up to 21 month highs. The US dollar, long a victim of
money printing, has staged a short term comeback, while the gold market was shaken as participants
considered the possibility, however remote, that the end of quantitative easing would eliminate the
inflationary fears that have in part been responsible for gold's spectacular rise. But an early review of
the effects of a cut back in Quantitative Easing clearly demonstrates that whatever optimism held by
Chairman Bernanke is ill conceived. Interest rates have shown that they may increase on the possibility
of tapering alone. Were the fed to actually follow through on its promise and actually try to sell some of
the mortgages on its books, would likely have dire effects for mortgages and the housing market. Falling
house prices would follow, spending and confidence would fall, unemployment would rise, ending any
hope of recovery while the U.S. lands smack dab in recession. All this before any real tapering has
begun!
Looking at present conditions, one might be confused by the confidence of Chairman Bernanke, as a
case can be made that what is needed is not a decrease in QE, but actually increasing extended QE. The
chairman himself has indicated that if the economy does not perform up to his expectations, he will
once again use QE. At that point, there should be a massive loss in confidence in the Fed, as it is clear
that inflationary policies have only made things worse; this will be the day of reckoning for the US dollar
and the stock market, while it will also be the time that the real benefit to holding gold is realized.