An Island

"No man is an island, entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friend's or of thine own were: any man's death diminishes me, because I am involved in mankind, and therefore never send to know for whom the bells tolls; it tolls for thee." - John Donne poem For Whom the Bells Toll

As the poem above illustrates, no man is an island.  I would also go on to say that no portfolio is an island and no country is an island.  For as much as we believe that we are insulated from global affairs and that we can hid from economic disasters unfortunately the reality is that we are very closely linked to events and affairs in remote parts of the world.  So when planning an investment strategy you need to take into account not only the investment's return and risk but also how it fits into the overall portfolio and then how that portfolio will withstand shocks from the outside world.  Talk about difficult!

Let's start with what I will term the "direct" influences on the portfolio; for example a company in which you have an investment has good earnings and the stock rises.  The impact on the investment is directly related to that investment.  These impacts give the investor the sense that their portfolio is an island that is only affected by direct influences.  Under these pretenses an investor would be forgiven for thinking that a portfolio where the investments show a certain lack of correlation is well diversified and therefore protected.  However looking at "indirect" influences might shed an entirely new light on the picture.

"Indirect" influences are varied and can be as remote as an earthquake in China to close to home such as losing your job.  When putting an investment portfolio together these "indirect" influences can actually be far more important than the "direct" influences in that they make up a larger portion of the portfolio and can have a magnified impact on the overall return.

Taking the close to home influences first a lot of investors make allocations based on what is perceived as a "normal" investment strategy and use a mix of stocks and bonds with little consideration even for these "indirect" influences.  The allocations are normally based on age and do not incorporate other "indirect" influences which is a mistake as leaving these off the table can destroy a portfolio quickly.  Some of the main "indirect" influences not considered are human capital, riskier employment and riskier home ownership.  Unfortunately this blog does not have the time to delve into each of these now (but I may in subsequent blog posts) but these "indirect" inputs often make up the bulk of the investment portfolio and are not considered.  Allocations into areas related to these inputs magnifies the impact of these thereby undermining the overall portfolio's resilience.  Furthermore allocations into higher risk areas when the "indirect" influences are already high in risk adds significantly to the overall risk of the portfolio and should be shunned for a more conservative approach.

Looking further afield complicates the investment process further.  In reality the idea that these influences can be predicted is asinine but with the global economy so highly integrated a general understanding and consideration of these "indirect" influences needs to be assessed during regular financial check ups.  While no-one has knowledge of what the next Black Swan will entail performing some kind of stress test on the portfolio would be helpful but unfortunately most stress tests do a poor job and often are not even considered let alone performed.  To me this is a big mistake and can expose a portfolio to unnecessary risks as, when the expected protection from diversification is most needed, it tends to evaporate.

In conclusion then your investment portfolio is anything but an island so ensure that you review carefully the impact of the "indirect" influences on your portfolio as these will have the largest influence on the overall returns of the portfolio.  Shunning an analysis of there will expose you to risks that will undo even the most carefully diversified portfolio.