Why Diversification Can Be A Bad IdeaJun Hao
I writing a topical email every week to my mailing list. Here’s our last email to subscribers which I thought I share.
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I’ve written in previous emails that concentration was highly dangerous.
In today’s article, I am going to make the case that likewise diversification (specifically unintelligent diversification) can be lethal to your portfolio returns.
Harry Markowitz called diversification “the only free lunch in finance.” The idea is that by diversifying, you can reduce your risk without suffering a loss in your returns.
So that’s your academic theory out of the way.
Let us talk about real life application. I am actually a believer in intelligent diversification.
For example – it makes a lot more sense to me that the average investor who does not have much free time should be buying a low-cost index fund rather than trying to pick stocks.
No arguments there.
The risk I see is that investors start diversifying for the sake of diversifying. This leads them to invest in things that they wouldn’t have otherwise, and really have no business in investing in the first place in the guise of diversification.
If I put aside academic theory for a moment, and put on my business hat, I should only be expanding my business in areas I have a core competence in and that I know well.
Every other new business area or geographical region that I expand into will entail new risks and “tuition fees” that will have to be paid.
Likewise, when it comes to investments, the complexity and risks of each investment are different. The less mainstream and opaque something is, the more likely is that there will be areas that you will be unfamiliar with.
Real World Case Studies
Let’s move this from the real of the theoretical into the realm of the real world.
You can imagine a situation whereby your financial advisor or relationship manager sits down with you. You have some cash, some shares in various unit trusts and are approaching retirement.
Your advisor tells you that you should diversify into bonds as you are getting older and should take some risk off the table.
Sounds perfectly sensible to you.
The only problem he tells you is that bonds have a minimum investment of $250,000 and that given your portfolio, you only can buy one. But not to worry, he has just the bond for you that will yield 5% per annum.
Again, this all sounds like perfectly logical advice. In fact, he tells you that you can even leverage up your bond with a Loan-To-Value ratio of 50% to generate an even higher return.
While the above story is entirely fictional in nature, it is not very far off from actual conversations that will taking place.
Investment Moats has a great article talking about it here:
You have a situation whereby an investor is getting what seems like perfectly intelligent advice – diversification into another asset class which should be less “risky”.
What in reality is happening is that he is taking extreme concentration risk into a highly cyclical industry into companies with weak financial positions and cash flows.
I have even seen situations whereby investors think that they are are well diversified… into several oil and gas bonds.
You can make the argument that what I am talking about isn’t true diversification. But semantics aside it sure looks like it.
So that’s my point – there is “diversification” and there is “diversification”.
The key here is intelligent diversification
Diversification is essentially protection against ignorance.
However, it alone is not an excuse not to understand or do due diligence on whatever you are investing in.
It is not a magic bullet to not doing sufficient due diligence.
Imagine the case that investors think that they own a diversified portfolio of bonds… only to find out later that most of the bonds are actually exposed to the same sector and economics.
This was exactly the case for many investors exposed to fixed incomes investors in Singapore in the last few years.
So, there is diversification and there is intelligent diversification.
I am a great believer in a simple asset allocation (low cost index funds).
The complexity that comes with dealing with more complicated products introduces more risks and pitfalls that the average lay person cannot understand.
To be frank, I am even quite dubious that even the relationship manager understands what he is selling at times given the explanations I have heard.
I have a strict rule that I won’t invest in anything without understanding it inside out and reading the relevant documentation.
At the same time, I understand that this is not possible for most people and that’s why I caution others into looking at complicated financial products.
I actually get the case for investing in real estate very well.
It might not generate the highest return over the long run,but at least you understand how it works.
So there we go – diversification done intelligently can be a powerful tool in your arsenal.
Unfortunately, it does not mitigate the need for you to understand whatever you are investing in and relying it as a “hedge” against not knowing is very likely to end in tears over the long run.
Article by Jun Hao, The Asia Report