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The Diversification Imperative

When Conventional Wisdom Understates The Case

 
Diversifying your investments is classic advice. If anything, it is underpracticed. This might sound strange but don't worry we will take a closer look at what diversification really means in a future note. The point of this note is to make an even stronger claim than just "I recommend you diversify".
 
My claim is:
If you do not diversify you are incinerating wealth.
 
Why?
 
The reason is grounded in theory but better explained via logic. Let's imagine there is a universe of investments that are fairly priced. Nothing offers an unusually attractive prospect of reward compared to risk. Suddenly a new investment opportunity is presented to the world that appears to have especially favorable qualities (extra return, less risk, or low correlation with the market). Let's consider the scenarios:
 
  1. The potential return above-average + low or average risk → Everyone will buy it. Price will rise until the expected return is driven lower
  1. Extremely high return potential but very high-risk → Investors with large bankrolls who can tolerate the swings will bid up the price
  1. Risk reward commensurate with the market but less correlation → Investors who understand portfolio math will be willing to bid it up driving its expected return lower.
 
The principles underlying these scenarios, in order:
 
  1. The merit of any investment can be ruined if you pay too much.
  1. Risk is not an absolute concern. Its suitability depends on the bankroll.
  1. Uncorrelated investments dramatically dampen volatility at the portfolio level.
 
This leads to a powerful conclusion familiar to finance professionals:
You are not paid extra for taking diversifiable risks.
 
I've always found that statement difficult to internalize. Re-stating it:
Any standalone investment with favorable qualities will be bid to the point where it looks overpriced when viewed in isolation.
 
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A homebuyer with access to fire insurance can afford to pay more for a house. To everyone else, the house is "overpriced".

Diversification Is An Imperative

 
As we previously established markets are efficient, at least from most investors' vantage point. That means diversification is not just recommended, it actually represents an upperbound on what it the optimal risk reward when dealing with public¹ investments.
 
Taking unnecessary risk with a concentrated portfolio is not something you are rewarded for. Of course, in practice, your outcomes will vary from theory leading to under or overperformance. A casino has a 1% edge on the dollars bet at the blackjack tables. But for any one gambler, the actual results will almost always be wildly different. The theoretical profit requires a large sample size. But make no mistake, the casino's theoretical vs realized profit converges over time.
 
The same is true for investors.
 
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If you are not diversifying you are incinerating theoretical money in terms of expected risk/reward.

Prepare Yourself From Your Future Self

 
The downside of diversification is that when you look back at your portfolio you will always regret not putting all your bets on what turned out to be the best horse.
 
The antidote to this regret is easy:
When you periodically look at your portfolio jot down a simple ranking of which investments you think will fare best over some time frame. When you look back you will see that your rankings were worthless predictors. That's all you need to give the concept of diversification its day in court. It will have all charges dropped against it.
 

 
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  • A casino that offers roulette and slots can afford to accommodate more tourist betting than a casino that only offers roulette. That casino can therefore afford to undercut other casinos and remain equally profitable in risk/reward terms. If you scale this logic up, you realize that the highest bidder for any opportunity is the entity that is most efficient in warehousing the associated risk. So individual investments are almost always overpriced from your point of view. This is idea is fundamental but bears repeating in many ways, but it can be hard to internalize. Useful reads:
    • Why You Don’t Get Paid For Diversifiable Risks (Link)
    • Is There Actually An Equity Premium Puzzle? (Link)
    • DCF As A Lower Bound (Link)
    • The Beauty of Option Theory (Link)
      A final example comes from portfolio theory in general.
      Portfolio theory shows us that if we have 2 assets that are only loosely or perhaps negatively correlated, a portfolio comprising a mix of both assets can have a better risk/reward than either of the components. In You Don’t See The Whole Picture, I give a simple math example to demonstrate this principle.
      This principle has a deep implication — it means you don’t get paid for taking diversifiable risks. If I own a sunglasses company, I am the most “efficient bidder” for an umbrella company because I can diversify my weather risk. If markets are liquid, transparent, and the world transmits information cheaply then I should only expect to get paid for risks that are systematic, not idiosyncratic. Idiosyncratic risks are the types that can be diversified by being held by a party who owns the opposite type of risk (like the sunglasses/umbrella example).
      A real-world example of this is the vol premium in oil puts when Pemex conducts its annual “Hacienda” hedge. Pemex, Mexico’s national oil company, hedges its forward production by buying puts and put spreads on oil futures. Typically this increases the value of the puts, enticing risk capital and arbitrageurs to sell the puts at a price that they believe exceeds their replication value.
      However, I remember a year when Delta Airlines sold them the puts at a relatively fair price. This was a win for both Pemex and Delta. Delta is happy to sell the puts because they are “natural buyers” of oil via jet fuel (Delta also owns a refinery!)
      This is a great example of markets doing their job. A risk that could be diversified was paired off between natural counterparties. However, from another perspective, this is bad news for investors who expected to earn the “sell expensive puts” risk premium. If a risk premium exists but it diversifies another party’s exposure, then that party can afford to pay more for it than the standard speculator. So the efficient frontier for speculators is just the set of investments that contain systemic risks that cannot be hedged.
      The most obvious example is the equity risk premium in general — the corporate world is levered to financial growth. Corporations are owned by people in the population. Once all risks are netted, there is no stakeholder remaining who benefits from economic collapse. Therefore the only carrot to entice someone to invest in corporations, effectively doubling down on their reliance on economic growth, is a yield in excess of the risk-free rate. That’s an undiversifiable risk premium.
 
  • To understand correlation's impact see Your Portfolio Intuition Is Poor (Link)
 
  • For a simple math example to show how the diversification benefits of an asset can benefit a portfolio EVEN if the asset has a negative expected return see You Don't See The Whole Picture (Link)
 
  • The CFA did a comprehensive study of commodity returns and a key finding was:
    • Commodities do especially well during periods of inflation with the attribution due to spot returns. In fact, this is considered a potential reason why commodities offer lower expected returns than stocks. There is less compensation required because you are receiving a high inflation hedge.
       
      In other words, the standalone benefits of investing in commodities are absent. Unless you are diversifying them with other investments you are losing. Likewise, someone investing in stocks can afford to pay more for them theoretically if they have diversifying exposures in commodities. (Unfortunately the link from my notes is dead)
 

 
  1. If you had private access to a machine that accepted pennies and spat out dollar bills this would be better. But the moment that machine were accessible to an open market its price would at minimum trade at a price that made the so-called global portfolio more efficient