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Is Your Stock Portfolio Facing a Systemic Risk?

Understanding why “diversification” can hurt you

The last week in stocks was a wild one, and everyone seems to be talking about it. You could practically smell the panic when reading publications like The Wall Street Journal. The latest edition of Bloomberg Business Week is covered with bears – literally. More than anything, even though the markets stabilized during the later part of the week, I think people are still very uneasy about falling into yet another Great Recession like we had just a few short years ago.

Are you really surprised?

This is not surprising to me. I’ve said for a long time, dating all the way back to my book Rich Dad’s Prophecy, that there was a good chance we’d see massive upheaval in the stock markets. In that book, I predicted that the biggest stock market crash in U.S. history would happen sometime around 2016 – maybe we’re seeing that happen now, and maybe we’re not. If I had a crystal ball, I’d be the richest man on earth.

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This shouldn’t be a surprise to professional investors. Most professional investors understand that the stock market is overvalued. Just a couple months ago, even Janet Yellen was pounding the drum that stocks might be overvalued. In fact, what makes professional investors professionals is that they don’t panic in times like this. They instead use their financial intelligence to make a lot of money while others simply crash and burn.

All cards on the table, stocks and paper assets aren’t my thing. I prefer real estate, business, and commodities. If you’ve read anything of mine for any amount of time, that’s not surprising to you. But paper assets are important, and if they are your investment vehicle of choice, you can do very well in any market.

Because stocks aren’t my thing, I have great advisors who help me with them, especially Rich Dad Advisor, Andy Tanner. After all, business is a team sport and the richest people in the world surround themselves with experts who are much smarter than them.

Understanding systemic risk

Last week, during that 1,000-point drop, Andy gave some great insights into the difference between systemic and non-systemic risk on his blog. Watch his video here.

Simply put, non-systemic risk is when a company or a stock is performing poorly as an anomaly to the rest of the market.

Systemic risk is when the entire market is performing poorly as a patterned whole.

Understanding the difference between systemic and non-systemic risk is important, because it allows you to understand when the standard investing advice of “invest in a diversified portfolio of stocks, bonds, and mutual funds” is really going to bite you - hard.

Are you really diversified?

For instance, last week, during the market tumble, The Wall Street Journal published an article called “5 Tougher Questions to Ask Your Adviser.” One of those tougher questions was: “Is it time to rebalance? If not, why?” Writer Karen Damato says:

When stocks tumble, adding to stock holdings by selling better-performing assets can bring a portfolio back to a target asset mix that should be appropriate for a person’s risk tolerance and goals. It also forces investors to buy low and sell high, which sounds obvious but is uncomfortable in practice. There are differences in opinion on how often portfolios should be rebalanced, but a consistent approach avoids emotional investing.

In a non-systemic risk market, this is conventional advice that probably won’t hurt you. But in a systemic risk market where everything is falling, rebalancing – or diversifying into other paper assets – won’t help you. All paper assets are tanking!

Why is this? Because diversification, as most financial advisors call it, isn’t really diversification. It’s just buying different types of stocks in the same asset class – paper assets. And when paper assets are facing a systemic risk, your “diversified” assets all fall. True diversification means having investments in all asset classes, not just one.

The difference between amateur and professional investors

As Andy says, “Risk is related to control.” In a market with systemic risk, you can’t control whether a stock or a group of stocks will go up or go down. But what you can control is whether you are long or short. Again, to quote Andy, “You can’t control the market, but you can control where you are positioned.”

What Andy is talking about is the difference between amateur and professional investors. Amateur investors think that “diversification” will protect them. Professionals know that hedging will protect them.

In the stock market, long and short positions are like insurance that hedge against losses, and if you are financially educated, you can read the patterns in the market and know when you should go long or short in order to generate gains and minimize your losses.

Get financially educated to thrive

Long and short positions are a part of technical investing that requires education, but if you want to move beyond being an amateur to being a professional, it’s worth your time to learn this. That’s why we offer courses on technical stock trading at Rich Dad, to equip you to be financially free in whatever asset class you choose.

I don’t know what will happen in the markets over the coming days, weeks, and months. But what I do know is that those who forgo the conventional advice of “diversification” and instead educate themselves on advanced trading techniques will thrive, no matter what the market is doing. Meanwhile, others will simply try to survive.

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Original publish date: September 01, 2015