Is Diversification Important?

It is a near sacred belief that the best portfolios are diversified. Is the belief valid?

Fidelity Funds offer this reason.

“Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.”

Reducing your asset concentration limits your expectation of loss. And, simultaneously your expectation of gain.

Investopedia suggests this about diversification:

“It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.”

Optimize returns, as opposed to maximize returns may be true. You cannot maximize returns by reducing “investment risk.” Minimizing investment risk means minimizing volatility.  That has little to do with returns.  It has a lot to do with reporting values.

You may recall that volatility is the investment analog for risk. Year to year volatility is meaningless unless you might need all of the money at a moment’s notice.  Few do. Even after retirement it is unusual to need it all at once.

Warren Buffett suggests a different reason to diversify:

“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

Buffett and Munger do not rely on diversity for their wealth.  They rely on skill, discipline and patience. Uncommon characteristics for most of us.

Investopedia’s idea about maximization is likely true, but not for investment reasons.  It is because people are emotional and wide swings of value on either side of zero bother them.  Diversity induces a certain amount of stability and that tends to keep people’s thinking in their rational space.

Buffet’s view that volatility is not an analog for risk means other factors matter. Like the possibility of permanent loss of capital. You could analyze that possibility and it would have little to do with volatility. The risk of loss and the risk of profit is greatest without diversity. People don’t think about risk of profit very often.

Buffett’s risk ideas are summed up in two thoughts:

“The first rule of investing is don’t lose money.”

“Risk of loss is what happens when you don’t know what you are doing.”

We are emotionally attuned to loss being established on a given day by the market pricee of a security. For a diversified portfolio some will be up and others down, so the emotional cost of down is minimized.  For Buffett, market fluctuations mean nothing, so diversifying to minimize volatility is equally valueless.

When you think about it, the only times market price matters is when you are buying or selling.  If you are doing neither, why pay attention.

But we do.

Our “lizard brain” does not like the feeling of loss.  It likes wins, but not as much as it hates losses. It does not notice details. A business is worth what it can earn.  That business value is not tightly connected to what the market offers is too deep. Our higher brain can deal with it, though.

The stock market is a pricing mechanism, not a valuation method.  It’s simple.  If you assume market price and business value are identical,  or you cannot make the lizard brain be quiet, you should diversify.

The end game is this.  Again from Buffett

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices

Diversity is not your friend if you can manage your emotions, know that market price and value are barely connected, and have some skill in finding and valuing businesses.

For the other 98% of us diversification makes life easier, but necessarily less profitable. Peace of mind has a price.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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