The Myth of Diversification

Diversification.  One of the most established tenants of investment strategies taught throughout academia and the investment world. If you’ve met with financial advisers (FA) or portfolio managers they probably mentioned this at least a five times in one sitting.  How you need to buy forty different stocks in ten different asset classes and industries – which makes hard for decision making and requires their help to do so.

However, if you study the most successful investors they don’t necessarily follow this mantra.  In many cases, they debunk diversification.

Don’t just take my word for it.  Look at the numbers.  Joel Greenblatt of Gotham Capital earned a 50% return percent annually from 1985 to 1994 while the S&P 500 return 15.1%.  In his book You Can be a Stock Market Genius he says,

[B]ased on past history, [the] average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year’s return falling between -8 percent and +28 percent are about two out of three.  In statistic talk, the standard deviation around the market average of 10 percent in any one year is approximately 18 percent.  Obviously, there is still a one-out-of-three chance of falling outside this incredibly wide thirty-six-point range (-8 percent to +28 percent).  These statistics hold for portfolios containing 50 or 500 different securities (in other words, the type of portfolios held by most stock mutual funds).

And here comes the interesting part, if you own five stocks you have a two-out-of-three chance your return will fall between -11 percent and +31 percent.  Your expected return is still 10 percent like above.  If you own eight stocks your return will likely fall between -10 percent and +30 percent and your expected return is 10 percent.

Diversification hurts performance if you do it just for diversification’s sake.  For example, there are two stocks you are considering to buy.  Stock A is fantastic buy and Stock B is a decent buy.  You fear putting all your eggs in one basket so you put 50% in Stock A and 50% in Stock B.  You have just diversified downwards. Diversifying downwards only hurts performance and is one of the silliest things you can do.

It gets more silly when you dilute your portfolio from owning five great stocks into owning thirty mediocre stocks.  Now you have to find thirty good buys instead of five.  And along the way you might have to move beyond what you know (and are comfortable with) and venture into unknown lands in which your money might not return.

Mark Twain said it best, “Put all your eggs in one basket and watch that basket.”  Next time someone throws around the word diversify, think twice.

By |2018-12-13T08:36:12+00:00May 22nd, 2010|Uncategorized|