Diversification Dimensions and Pyramid Investing

Pyramid Investing is rather simple investing concept based on price diversification.

Common ways of diversification – Dimension one

It is well known that diversification in general, reduces investment risks. In other words, diversification helps protect investor from losing money. This is not necessarily true. If the market goes down, investor’s diversified portfolio will most likely go down as well. Therefore, to be more precise, it can be said that diversification makes the portfolio behave similarly as the market in general. When market goes down, investor’s account value goes down. Conversely, when market goes up, investor’s account value goes up. Thus, diversification gives the investor peace of mind that his or her account is not going to diverge significantly from the market. This may be beneficial when the market goes down, but unfortunately it works both ways. Along with the peace of mind on the downside, it prevents the investor to “beat the market” on the upside.

Thus, there are at least two problems with common portfolio diversification:

• Should the market experience a crash, the investor’s portfolio crashes as well
• Investor’s portfolio is very unlikely to beat the market which is very boring since market rarely “crashes” on the upside

Anyone who has experience with common mutual funds knows how their performance closely tracks the performance of the market in general. Usually it takes years to accumulate some noticeable gains. On the other hand, market crashes that happen from time to time tend to wipe out those gains. Even very long periods cannot guarantee that the investor will make real returns. Why should the next 40 years yield the same as the last 40 years? Even if you could get that guarantee in writing, how likely are you going to be able to sit on your investment for 40 years and do nothing?

Common diversification assumes:

• You bought different stocks in your portfolio
• Or you bought some stocks and some bonds
• Or you bough stocks in different market sectors
• Or you bought some domestic and some foreign stocks
• Or you bought some large cap and some small cap stocks
• Or you bought a little bit of everything
• Or you just bought one or more mutual funds

As you can see, combinations are almost limitless. You can diversify in any way it strikes your imagination. Do you see a problem in this diversification beside two problems mentioned above?

There is a common thread to all these possible approaches to diversify – all of them, more or less, do the same thing. Thus, diversification is only seemingly achieved. We can also argue that diversification is done within one dimension only.

Another common way to diversify – Dimension two

So the question is: Does another diversification dimension exist and how can we find that other dimension in order to diversify our portfolio even more? Well, other dimension does exist. And probably all of you, who have your US 401(k) accounts, or other equivalent pension plans, are exploiting this other diversification dimension already. That dimension is time. You are actually diversifying in time with your regular weekly, bi-weekly or monthly contributions automatically taken out of your paycheck and invested. You add to your pension investment portfolio a little by little each time you get your paycheck. This approach is also well known as “Dollar cost averaging”. You buy less when market is high and you buy more when market is low. And that is because each time you invest the same dollar amount.

You don’t need to have a 401(k) plan in order to time diversify. You can basically do it in any investment account. Let’s say you win a lottery. So suddenly, you have a lot of cash that you don’t know what to do with. You know you don’t want to spend everything right away so you decide to invest it. But you wonder, is it a good time right now to plop all that cash into a diversified portfolio? Or should I wait and the market may go down, so I’ll get to buy more for my money. You decide to wait, but the market starts going up instead of going down as you hoped. You find yourself missing an opportunity to buy as it keeps going up and you decide to plop it anyway. Then the market crashes!

Probably, you would do much better if you time diversify. So instead of plopping all your money at any one time, you decide to split your investment capital in, let’s say, 24 equal chunks. Then every first of the month in next 2 years, you use one chunk of your capital to invest it at whatever the price happens to be. So you dollar cost average. If you’ve been buying diversified additions to your portfolio, it means that you have been diversifying by two dimensions! Of course, chunks of your capital that are waiting to be applied are sitting in some cash account and preferably earn some interest.

Now, you can be very proud of yourself that you diversified by two dimensions, but the overall performance of your portfolio still gets to be very close to the performance of the market in general. You may get lucky if the market crashes early while you are still mostly in cash, or if strong bull move occurs at the end of your two-year period after you’ve been almost completely invested. But there is no guarantee that complete opposite is not going to happen. That would be very unfortunate for you and your portfolio. If you really got it on lottery, you might say – easy come, easy go. But if it was hard-earned capital, you may end up as a total emotional wreckage even with both two dimensions of diversification.

In other words, anything can happen. Thus all your efforts to diversify and protect your portfolio may become fruitless. Logical question to ask is: Is there any other dimension of diversification that one can apply to prevent from potentially wrecking the portfolio?

Uncommon way to diversify – Dimension three

The answer is YES! Third dimension of diversification is price diversification. It is actually diversification that arguably can be applied as the only dimension of diversification. And price diversification is exactly what Pyramid Investing is based on. Although, it is not the only basis of Pyramid Investing concept, price diversification is one of the major ones.

Price diversification means investing chunks of capital at different price levels. In general, the more price levels, the better the price diversification achieved. Naturally, number of price levels has some practical limitation. However, regardless of the number of different price levels, this approach has some extremely favorable traits. Price diversification is what makes Pyramid Investing so powerful and profitable.

To summarize, there are three distinct dimensions of diversification:

• Diversification by asset class, capitalization, geographical region, sector etc…
• Diversification in time or dollar cost averaging and
• Price diversification

Each diversification dimension can be utilized by itself. Any combination is possible too. However, the only diversification dimension that works excellent when applied alone is price diversification. Price diversification is superior to any other diversification approach. And yet, price diversification is the least known or used diversification within any group of investors whether amateur or professional, individual or institutional, inexperienced or experienced…

This is one of the reasons I created Pyramid Investing blog – to educate investors alike about neglected area of investment knowledge – investment knowledge jealously kept as a top secret by the most successful professional investors in the world.

What I plan to present to you in this blog is precious information and yet I am willing to freely share it with anyone interested to read. I only ask for your patience and cooperation. Sometimes even the simplest concepts may happen to be the most elusive to grasp. And this simple one is capable of making you some good profits if you are persistent enough. Because consistent profits are achievable, after all!