Like most modern countries, Japan has an enormous investor community and a vibrant (though in recent years, lackluster) financial exchange. A person living in Japan who invested would probably have the bulk of his or her portfolio in Japanese equities and Japanese government bonds. The catastrophe facing the Japanese people has caused me to revisit diversification and how thinking about it can help to create a portfolio that can weather almost any tragedy.
Does diversification work?
Diversification is a very vague term. It is essentially the act of buying different asset classes in order to weather a downturn better. Traditionally diversification was limited to the buying of stocks and bonds. If stocks went down in value, bonds would go up. This has been shown to be the case in recessions which follow a stock market crash.
But there is another type of diversification that has gained popularity in recent years. Not only do investors diversify into different asset classes, they also diversify into different investment companies. This makes a lot of sense. In a severe recession, you can expect investing companies of all kinds to collapse. In this most recent recession we saw bank collapses become routine. Some very old investing firms like Lehman Brothers and Bear Stearns also went the way of the dodo. By having your money in different investing companies, even if one goes under in a market crash, you will still be able to save some of your assets.
But what if the entire system comes crashing down? In Tunisia and Egypt we saw all trading stop in both the local stock exchanges and bond markets. Even if you had diversified into different asset classes or different investing companies, your money would have been completely frozen. The market is at the mercy of the government’s ability to function. Without a country, there is no market.
What is happening in Japan is certainly scary enough to make an investor think about how to diversify assets abroad in such a way as to avoid a local catastrophe. I personally don’t believe we will see Japan collapse but I think if radioactivity were to spread to Tokyo, we could see a cessation of trading for some time.
But how can you diversify away from a closed market?
The common belief is that if you own shares of foreign stocks and bonds, you will avoid your own personal catastrophe if the local markets of the country you work in close down. The truth is that having accounts with foreign brokers is often very difficult and not tax friendly. Storing money overseas is also often illegal.
There is no good answer to this issue. If you own foreign stocks, you most likely own them through a local broker. If the markets of the country you live in close down, your broker may cease operations as well. It would really depend on the type of emergency that is facing the country you live in. If it is a political situation, the broker or fund may still be up and running. If it is due to a natural disaster and people are evacuating an area, the broker may not be available.
The only way to truly diversify is to have money in several parts of the world at the same time. This is almost impossible for most people to accomplish however. It is routinely done by the very wealthy and the very powerful. Witness the great efforts to freeze Gadafi’s assets that are found in bank accounts and properties across several continents.
Gold steps in
Ownership of gold, at least enough to live on until markets re-open, is the poor man’s diversifier. Of course if you have to leave an area quickly to dodge a tsunami, you will not take the time to move your gold hoard into a car. You will instead run to safety as quickly as possible. But for many other emergency scenarios, getting to your gold and using it to get out of a country is a real possibility.
I recommend that all investors have a dollop of gold in their portfolio. The more I read about market collapses and the struggles of expats to leave disaster areas to safety, I realize how important gold can be to calming a portfolio’s volatility and how gold’s inherent value makes it an ideal currency if the local paper currency has become worthless.
That does not mean I think speculating in gold is a good idea. It is a terrible idea. Gold is a volatile asset. It should only be used sparingly, no more than 25 per cent of your assets. Gold’s behavior is random and it does not build wealth. Rather, it saves wealth. Every country on earth recognizes the value of gold.
