On Diversification
It’s okay to keep at least some of your eggs in one basket.
Don’t put all your eggs in one basket. You’ve probably been told this at some point, probably even many times. Probably from an adult, probably when you were young and probably as a warning. The sentiment itself probably dates unknowably far back into prehistory, perhaps as far back as consciousness itself. Ancient religious texts include similar verbiage, though it wasn’t phrased precisely as such until the 1660s. 1
Just as living organisms slowly evolve over time as their fitness changes, so do ideas. Ideas do not persist largely unchanged for millennia unless they are very wise and broadly useful. As currently incarnated, particularly within the present scope, the idea is simply expressed as “diversification.”
Diversification, or the concept of diversity more broadly, regardless of the discipline to which it is applied – finance, agriculture, ecology, sociology – is fairly intuitive to any thinking person. A dictionary definition here, as in such columns past, is unnecessary to create common understanding.
Similarly, belief in diversity as a positive good is pretty much universally agreed upon. Diversification is widely considered safer, because not all of your eggs will break if you drop one of your baskets, and more desirable, because variety is the spice of life after all, than the alternative.
Specific to finance, diversification offers the promise of improved “risk-adjusted” returns. In laymen’s terms, this means that, by combining assets that zig with assets that simultaneously zag, overall portfolio volatility can be reduced by more than any accompanying reduction in overall portfolio expected return. This is premised, of course, on the academic supposition that volatility is synonymous with risk. Regular readers will recall that I spent nearly 2,500 words back in May 2023 expressing my reservations with that equation. Nevertheless, for different reasons, the concept does have merit and holds wide purchase among the investing community.
Diversification can eliminate asystemic risk from an investment portfolio, leaving it to be affected only by the ups and downs of the broader market (systemic risk) rather than by the ups and downs of the individual holdings. If one of your holdings turns out to be fraudulent, to use an extreme example, and declines sharply in value perhaps another within a properly diversified portfolio would have a compensating unforeseen, positive development, or so the theory goes. It never works that cleanly in practice, but it actually does work.
At the end of the day, things can and often do go wrong. 2 Diversification cannot protect against that, but it does protect against any one thing going wrong AND consequently causing undue harm. Might there be drawbacks to diversification though? Might diversification not be the unalloyed good that it is commonly considered? Yes, absolutely. Like much in life, the reality is less ideological and more nuanced.
Diversification, if not done properly, for the right reasons or to too great an extent, can certainly cause harm as well. Perhaps not as great of harm as a lack of diversification may cause, but real, tangible harm nonetheless.
Diversification, if done to too great an extent, can introduce unnecessary complexity into an investment portfolio. An overdiversified investment portfolio lacks clarity and purpose. It becomes a shapeless mass. It devours not only your ability to understand what it is comprised of and intended to accomplish, but also your ability to make timely, clear and effective decisions.
Diversification can be done for the wrong reasons as well. It is sometimes used more as a sales tactic than as an investment principle. Complexity sells better than simplicity and is usually more profitable as well. The only result for the client, though, is excess and unnecessary fees that are highly detrimental to long-term investment returns.
Diversification can also be done improperly. In many cases, incremental investments made in the name of diversity are redundant or overlap with existing investments. Often investment portfolios hold too many stocks, far beyond that required to diversify away asystemic risk. Between 15-50 is thought to be sufficient; many mutual funds hold far, far more. They do so to reduce tracking error versus their chosen benchmark, often at the expense of long-term investment performance. They do so not because they are ill-informed, but because they have the wrong incentives. Too much tracking error and their clients begin to leave. So better to perform a little worse than might be possible but still keep your job.
Likewise, diversification can be abused for byzantine reasons. Back in July, the Nasdaq 100 Index, a market capitalization weighted index, moved to limit the weighting of certain constituents, effectively overdiversifying the index relative to realty. This is believed to have been done to allow mutual funds tracking the index to comply with rules outlined in the Investment Company Act of 1940 that must be satisfied before they can be marketed as “diversified.”
If diversification is not always a good thing, you might be wondering if undiversification 3 is sometimes desirable. Turns out that it is. Undiversification can make you very, very rich IF you choose the right investment. Easier said than done, of course, but the fact remains true. So what is the right investment then? Ultimately, diversification is a necessary mitigant when operating alongside uncertainty and risk. If outcomes were certain, there would be no need to diversify. If a visitor from the future told you what the best performing investment over the next ten years would be, you certainly wouldn’t think to yourself: “I should add a bit of that my otherwise diversified portfolio.” No, you’d put your whole portfolio into the investment and, if you were smart, borrow money to invest even more. 4
Obviously, that is a bit farfetched, but the general principle holds. The degree of diversification required is determined by the “rightness” of the investment and how material the potential loss could be. Rightness, in turn, is a factor of your knowledge of the investment, your control of the investment and your certainty of the range of outcomes. While that is heretical to the prevailing orthodoxy, we willingly accept undiversification under similar pretenses in other parts of our lives.
Every day, entrepreneurs risk everything, literally mortgaging their homes in some cases, to start and grow a business that they believe in, but more importantly, that they can control. This type of undiversification, no less risky, is actually encouraged and celebrated. Even the simple act of choosing a career, a specialization, is an act of undiversification. 5 No one blanches at that.
It’s not a complete stretch to say that long-term success seems to require at least a period of undiversification. Great success seems to rely on it almost exclusively. Take a quick look through the Forbes List and learn how those people built their wealth.
Unfortunately, while undiversification is a great way to build great wealth, it is also the best, most efficient, 100% perfect, surefire way to go completely broke almost instantaneously. There is no Forbes List for the people who risked it all and lost everything. If there were, it would be incalculably long. 6
For the vast majority of us, building and protecting wealth requires finding the right amount of diversification. This will depend on the particular characteristics of your unique financial situation, investment portfolio and personal temperament. The right amount of diversification is different for everybody and also changes over time. If that doesn’t sound hard enough, there is no way to know for certain if or when you’ve achieved the right amount of diversification. No one rings a bell for you when you’ve found it. There is no diversification gauge that fills up as you approach the optimal level. Ultimately, this is a complicated, continuous effort and exercise, one best undertaken with the benefit of much hard-won experience and expertise accumulated over years. For starters though, know that it is okay to keep at least some of your eggs in one basket.
Thoughts? I would love to hear them. Email me at investmentinsights@zuckermaninvestmentgroup.com.
Written By Keith R. Schicker, CFA