A Tortoise Investor's Best Defense

It's all about diversification.

Let's assume for a minute that the odds are against you when trying to time the market. The costs to transact and the likelihood that you would mis-time your movements are simply too high. There is substantial empirical evidence to suggest that this is the case. Your best remaining option is to try and devise an investment strategy that relies upon continuous investment over long periods of time. You should allocate your portfolio in a meaningful way with a deep understanding of the potential downside risks involved, having looked at the worst periods available for your allocation. The last month and year could serve as a good proxy.

Thanks to the Capital Asset Pricing Model (CAPM) provided by economist and Nobel Laureate William Sharpe, we know that the most effective way to reduce a portfolio's overall risk while not substantially effecting the expected return is through diversification. In this sense, diversification does not mean holding 30 stocks as opposed to 10....it's more like holding 17,000.

There are two broad categories of risks associated with investing in stocks. Unsystematic risk, which are risks such as a company fails or all the companies in a particular industry sector suffer for one reason or another. The good thing is unsystematic risk can virtually be eliminated through proper diversification. The other broad risk is the systematic risk of the market as a whole. Systematic risk includes macroeconomic conditions affecting all companies in the stock market and cannot be diversified away. Today's credit crisis is an excellent example.

Investors can expect long-run compensation in the form of a risk premium for accepting systematic risk. The same can not be said for investors who accept risks that can ultimately be diversified away.

Below is a cartogram representing the market capitalization, as of the end of 2007, of each country's stock market relative to the world's total market value:



A well diversified portfolio would have some exposure to each of these markets. As it's impossible to predict which of these markets is likely to perform well in any given time period, one would benefit from investing in all available. The stock portion of our portfolios usually contain 60% U.S. stocks, 30% Developed Nation non-U.S. stocks and 10% Developing Nation non-U.S. stocks. This stock portion may be as little as 20% or as high 80% of the overall portfolio, depending on the risk tolerance and needs of the investor.

Regardless, each of our portfolios has some exposure to stocks, but that exposure is as diversified as possible, leaving only the systematic risk of the market behind.

Sticking to a Tortoise Plan

Today I made a contribution to my IRA and invested it my tortoise investment strategy. That's right, I made the decision to increase my investment in the stock market. Some of the readers of this post might think it foolish to put more in the market right now. So, why did I make this contribution? Because it came up on my calendar to make the transfer as part of my long-term savings plan, and I see no reason to change it. In fact, I see this current economic crisis as an opportunity.

Warren Buffet has many famous quotes, but one of my favorite is: "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." You'd be hard pressed to find a time when the average investor was more fearful than now. I wonder if this is the mentality driving Berkshire Hathaway's recent decisions to invest in GE and Goldman Sachs, both struggling companies.

Though I try to check both the emotions of fear angreed at the door when I make investment decisions, I see this contribution to my IRA today purchasing more shares than I was able to purchase with the same contribution last Spring. Assuming I will be hanging onto these shares for decades to come, I'm happy to purchase them at today's fear laden prices.

Don't get me wrong, it's been painful watching the value of my retirement accounts decline over the last year and months and especially the last few weeks. It's been even more painful watching the value of my client's accounts decline. But as a tortoise investor, I also have the ingrained expectation that troubling economic conditions are bound to happen from time to time...knowing I am better off over the decades weathering the storm as opposed to trying to time the top and bottom of each boom and bust.

I've realized lately that expectation is everything when it comes to making sound investment decisions. It's like 2 doctors each giving you a shot. The first says, 'this might hurt a bit'; and the second says, 'this won't hurt a bit'. The fact is you are going to feel some degree of pain, perhaps not as much as expected with the first doctor and certainly more than expected with the second doctor.