The Folly and Bliss of Diversification
There is a tide of human emotion at play where it concerns most things humans do. Animal spirits have a way of influencing many outcomes, including the lines we draw in the sand and the positions we take when we’re investing.
In the normal day to day, we imagine much of what we want to believe and move toward it. Within the confluence of time and space, we arrive roughly where we thought, with our thoughts becoming things. Much of what happens along the way is random and we build stories around how and why these random events happen and they become part of what we believe in, until we learn otherwise.
What we learn otherwise about investing is how to deal with pervasive uncertainty. Here is a summary of what we know.
The human ability to focus is often all consuming and despite the enormous benefits of specialization, focus allows little else to occupy our attention. In the face of such pre-occupation it is difficult to know what we need to know, outside of our own circle of competence. When we don’t know what we don’t know, the over-confidence can jeoporadize our safety and become financially ruinous. It is the threat of delusion and other systemic risks that makes it necessary to have a safety mechanism to protect investors.
Diversification is the solution most widely adopted to protect against investment risk. The diversification solution works for the masses and the result is a “safe”, average, and homogenous performance. The average return will include the frictional cost of delivery and advice. The advisors and other helpers have vested interests and are the man with a hammer in a race to the bottom of cheap and efficient.
Low cost index funds, which are proxies for the market or subsets of the market, have become popular alternatives to a focused, value based approach. The broad based, one size fits all solution of diversification and index like performance makes perfect sense, in the absence of focused advice.
As capable as we are, we can’t (yet) swim through the water like a seal or fly with the efficiency of a bird, although our adaptations are nothing short of brilliant. Humans have managed to progress remarkably well through the expression of thought. Many words have been spoken and written about the protection of capital and one school of thought has proven to be a brilliant adaptation for pervasive uncertainty.
The world’s greatest investor, Warren Buffett, describes diversification as de-worsification, something fools do to hide their mistakes. Human ingenuity is capable of so much more than being average and we demand the best in nearly all areas of our life. Our capital markets are designed and regulated to function for the safety and protection of all members of the investing public and so the diverging, time tested principles used to obtain extraordinary results, are by definition not part of the main stream.
In the absence of learning what it takes to become extraordinary, the system default kicks in. The evolution of diversification strategies has brought us to the pinnacle rock, jutting out of the ocean, the whitewashed target for many sea birds and the cherished home of the lemming.
Next week, what it takes to avoid lemming like behavior.