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Diversification is not a free lunch

Harry Markowitz is reported to have said that “diversification is the only free lunch in investing”. This is the notion that holding a broader range of assets can result in better returns without assuming more risk. Over the decades this has become accepted wisdom – but it is not true. Diversification isn’t free; it is painful and difficult to achieve.

Why diversification is difficult

Diversification is a vital concept for investors. It is an acceptance that the future is inherently unknowable and can take many different directions. If done well it provides protection against both uncertainty and hubris. The best indicator of an investor’s overconfidence is how concentrated their portfolio is. If we could accurately predict the future, then we would only own one security.

Given this, why is diversification a problem?

Because it is behaviourally difficult. To be appropriately diversified not only means holding assets that will be a disappointment, but where we actively want them to disappoint in advance.

If everything is performing well and in concert, our portfolios are probably not diversified.

If we are appropriately diversified, we will look at our portfolio and see a collection of strong performers and laggards. Rather than be comfortable with this as an inevitable feature of diversification however, we will have the urge to make changes. Removing the struggling positions and adding more to those that have produced stellar results.

It is far more comfortable for our portfolios to be focused on the top performing assets rather than be genuinely diversified. It will feel like there is nothing to worry about – everything is working well. Although we are drawn towards this type of situation, it is merely a short-term complacency that will foster almost certain long-term pain.

Diversification is constantly put in jeopardy by our behavioural failings. For the assets that are outperforming in our portfolios, the prevailing market narratives will persuade us that this environment will persist forever. Conversely, the stories around the stragglers will make us believe that they will never deliver again.

When we are reviewing the performance of our portfolio, diversification often feels like a bad idea – because we could have always held more of the assets that provided the highest returns.

Hindsight makes diversification look unnecessary.

Things to remember about diversification

Given that maintaining appropriate levels of diversification is likely to prove a constant challenge for investors, there are two crucial concepts to place at the forefront of our thinking:

– Things will be different in the future: Markets are constantly adapting, things will be different in the future in ways that we are unable to predict.

– Things could have been different in the past: When we look at the performance of our portfolios, we assume that it was inescapable that this particular course had been charted, but, of course, this is never the case. In a chaotic, complex system, entirely different outcomes could have come to pass.

Diversification requires us to own positions that haven’t performed well, and we don’t expect to always perform well. That doesn’t mean we should naively hold any asset irrespective of its fundamental characteristics, but we must accept that to be well-diversified requires us to have relative slackers in our portfolios at all points in time.

Nothing that works in investing provides a free lunch, it always comes with some behavioural pain. For diversification, it is the acute sense of regret about how much better things could have been.

 

Joe Wiggins is Chief Investment Officer at Fundhouse (UK) and publisher of investment insights through a behavioural science lens at www.behaviouralinvestment.com. His book The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions.

 

6 Comments
Barry
December 05, 2023

The article is based on a total fallacy.
Diversity is across companies and sectors and geography etc, not across winners and lovers. The aim is to diversify across the winners. If a company is not performing it makes no sense to retain it just for the sake of diversity. What a woke idea.

CC
December 03, 2023

But Warren Buffet says most investors are best off putting 90% into the S&P500 index

richard goers
December 03, 2023

Not to labour the point - if ~ 5% of stocks create 100% of the wealth [resourced facts] then these stocks have particular attributes that make them successful - research is to find these attributes, even as they may change through time - their edge or moat - and history of their price action gives us thee winners Diversification, into ETF indexes like ASX200 or SP500 have the majority of stocks that dont make the cash rate as a return, or more to the point, the magnificent 7 stocks in the NASDAQ prove the point I dont see the rationalalisation to buy stocks that dont make a solid return above the riskless rate in their history but to seek out and look for the winners - as the rest are road kill if capital gains are the metric - nonetheless it cant be easy to do this research and take the risk appetite needed for a concentrated portfolio - so put 80% into a diversified portfolio and 20% into 'extreme' punts = aka BTC or biotech or AI or a concentrated AI portfolio - or if an Australian, investment houses

Graham Wright
December 03, 2023

Diversification! The greatest misleader perpetrated on investors managing their own investments. It is almost certainly a must for fund managers who have large FUM to invest and who have to consider the risk profiles of their investors. At the other end of the scale, business owners, especially in their starting years, have a single investment, their business, and a single product or service, all supported by committing the whole of their owned assets plus borrowings, to their investment. They usually have neither resources or time for diversification until the initial business succeeds. They put all their eggs into one basket and fully commit themselves to work for success. Diversifying our investments does not create wealth. Working hard to find the right investments and working to make the investments profitable is what works. The business manager works to make his/her future successful, no sitting waiting for the profits to roll in. They make modifications to their business as the business environment says change is needed, just as we investors need to constantly review our investments and make changes as the environment tells us that change may be needed.

Lyn
December 01, 2023

With thanks to author, your article gave me a perk as only yesterday reviewed a "laggard" with critical eyes on quarterly report I'd avoided, a will it or won't it? and a serve of self-doubt. It is hard to stick at diverse course, as inferred in part of Munger obit article the money is in the waiting so this edition gave a lone investor a lift even though inherently knew should not doubt decision to stick.

Julie T
November 30, 2023

Just because diversification is difficult to deal with psychologically doesn't make the theory wrong. Far from it. There's lots of academic literature supporting Markowitz. Though this article doesn't disapprove the theory, it makes some valid points.

 

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