Nobel laureate Harry Markowitz reportedly said that “diversification is the only free lunch in investing”.
However, this seemingly cost-free strategy comes with its own set of challenges and trade-offs.
The premise of diversification is rooted in the acceptance of an unknowable future. For those who believe they can foresee the future, a concentrated portfolio might appear more appealing. For them a concentrated portfolio would make sense. In fact, based on their conviction they should own only one security.
However, for the majority who grapple with the reality of uncertainty, diversification emerges as a logical choice. It serves as protection against overconfidence and various behavioural biases that often lead investors astray.
At its core, diversification spreads investment exposure across a range of assets, aiming to reduce overall portfolio risk. While it doesn’t eliminate risk entirely, a well-diversified portfolio tends to be more resilient against adverse events impacting any single asset or sector.
The essence of effective diversification lies in intentionally selecting assets with low or negative correlations. This deliberate choice acknowledges that not all assets will perform well simultaneously. A truly diversified portfolio should have both performing assets and underperformers at any given time.
If all the underlying assets or funds perform well in concert you are probably not well diversified.
What is the trade-off?
Holding assets expected to disappoint goes against human nature.
The knowledge of how diversification works does not protect us from this behavioural pain. The price of diversification is not monetary but behavioural.
The pain inflicted on investment portfolios often stems from the behavioural tendencies of investors themselves. We mistakenly assume that present circumstances will endure indefinitely. It’s a human tendency to extrapolate both positive and negative news into the future, leading us to overestimate the certainty of our predictions.
Looking back at the past, everything often appears obvious. However, within complex systems like markets, numerous potential outcomes existed at any given moment. Yet, we deceive ourselves into believing that a specific result was predestined. Consequently, when evaluating our portfolios constructed to withstand uncertainty, we experience remorse when viewed through the lens of hindsight’s false sense of “certainty.”
Hindsight makes diversification look unnecessary in retrospect. Reviewing portfolios tends to draw attention to underperforming assets, fostering doubt about the wisdom of diversification.
“It is far more comfortable for our portfolios to be focused on the top performing assets rather than be genuinely diversified. It will feel like there is nothing to worry about – everything is working well. Although we are drawn towards this type of situation, it is merely a short-term complacency that will foster almost certain long-term pain” – *Joe Wiggens.
Investors must recognize that the long-term well-being of their portfolios hinges on their capacity to withstand short-term behavioural discomfort. Certain underlying assets are bound to underperform periodically – a natural feature of strategic diversification.
Investors need to feel comfortable holding assets that are not performing well at a given time. Many investors sacrifice the long-term probability of meeting their objectives by attempting to alleviate short-term discomfort caused by market movements through frequent trading.
The paradox lies in the need to endure short-term discomfort for the enduring benefits that diversification offers over the long term.
Accepting this trade-off is crucial for investors seeking to build resilient portfolios capable of weathering the unpredictable tides of financial markets.
The above article was written and adapted by Marius Kilian.
* “Diversification is Not a Free Lunch”, Joe Wiggens, behavioralinvestment.com, 14 Nov 2023