Commentary
I am a firm believer that conventional wisdom leads to conventional results. Whether it is in areas of science, mathematics, or the arts I think a convincing argument can be made that no one ever did anything truly spectacular by following conventional wisdom. There is a reason for this and that is because conventional wisdom is not meant to help one outperform but to learn the basics and more or less blend in.
When it comes to markets there is the old adage that “the crowd is always wrong.” This seems to be conventional wisdom as well and I want to submit that when it comes to peoples’ investment portfolios the number one cliché of the crowd as well as supposed market experts is that you want to make sure you are diversified. I want to suggest that diversification ultimately is not designed to help you succeed, which is why most managers do not even outperform the market averages year in/out. It is designed to keep you in the game and usually behind the lead. If that is your goal then carry on diversifying as you wish and guarantee yourself mediocre to poor performance ad infinitum. If you want to outperform diversification has to be strongly questioned and the following are a few reasons why.
No Free Lunch With Risk Management
Diversification is often a hedge for ignorance or lack of skill. Managers don’t want to have to really do the hard work of finding themes or ideas that will outperform or sell ideas that are performing poorly, so they generally just size everything small and hope for the best. Even in the most diversified of portfolios, common sense will tell you that some stocks will do well while others will not. Personally, I have never met a manager with a great track record who doesn’t take regular losses, however, most of the public is often sold a bill of goods when it comes to how they don’t need to do that because they are diversified. If a manager said “hey we’re holding these dogs for you because they are small positions” that wouldn’t be as palatable so instead they say something to the degree of “this is why we’re diversified.” I would add that many of the complex schemes of asset diversification and blends of stocks and bonds are often second derivatives of this theme where one doesn’t have to sell and take losses.In Times of Turbulence, Diversification Is Potentially Riskier
In times of increased market stress and high volatility stocks historically are more correlated. In layman’s terms, this means that when markets are falling hard everything gets hit. So while the tide is going out some of your stocks are swimming along nicely but when it comes back in hard nearly all of them will get washed asunder. If you study the correlations of individual stock prices to the overall market indexes the correlations increase as prices fall. So when you want diversification to protect you most is precisely when it has the biggest challenges. This is precisely because it is not designed to help you outperform but simply keep you in the game. This is also a function of human psychology as when people panic they tend to sell everything, while when they are less fearful they tend to be more selective.Diversification Tends to Keep People Away From Higher Cash Positions
The whole goal of diversification is to avoid having to sell and move to cash, thus you spread yourself out thin and avoid the pain of getting hit in any one area. I already pointed out in times of turbulence why this is misleading and dangerous but an even more important point is that it ensures that you never have higher amounts of cash. What if you really like a specific opportunity or investment? Holding cash is a huge advantage to the prudent and disciplined investor because he or she is ready to jump on opportunity when it arrives. The over-diversified portfolio is licking its respective wounds with little to no cash available as they’ve just spread themselves thin trying to weather a storm versus being ready to take advantage of it. There is conventional wisdom that “he who has cash in a bear market is king,” and this is another adage that flies in the face of diversification. In this case, the question is which form of conventional wisdom is misguided? Obviously, you know the way I’m leaning.In laying out a few of these ideas I want to be clear that the goal is not to get the reader to abandon diversifying or all forms of conventional wisdom but more importantly to question their approach and strategy. Personally, I have studied some of the greatest managers and you rarely hear them speak about the wonders of diversification. You hear them speak of conviction, process, discipline, etc. Diversification seems to be an alternative to when you lack the former. I’ll leave it up to the reader to research and decide.
