Diversification

“The benefits of diversification have been known for over half a century. In the early 1950s, Harry Markowitz demonstrated that there exists an “optimal” portfolio which has the highest investment return for a given level of risk. For his work, which created the field of modern portfolio theory (“MPT”), Markowitz won a Nobel Prize in Economics in the early 1990s.” writes Nick Maggiulli here.

Diversification means spreading your investments across a variety of different assets, such as stocks, bonds, real estate, commodities, and alternative investments. The purpose of diversification is to reduce the risk of loss by avoiding over-exposure to any one particular asset or sector. By diversifying your investment portfolio, you can potentially minimize the impact of market volatility and protect yourself from significant losses. It is important to note that diversification does not guarantee profits or eliminate all risks, but it can help to manage risk and improve the potential for long-term investment success.

The trick, if it is one, as shown mathematically in MPT, is that we need to consider how the price of each investment varies with the others. Assuming they don’t move in lockstep with each other, there is an inherent benefit in owning lower-correlated investments. Doing so allows us to hold a more “efficient” portfolio, meaning either: (1) for the same level of risk, we can earn higher returns or (2) we can achieve a similar return level but at reduced volatility.

That’s the infamous free lunch investors get when they diversify. But if you look closely, that lunch ain’t so free.

For one, the late Charlie Munger called it “deworsification”. His point is that investors would be better off focusing on things they know, reach a point when they know them well, and reap the benefits, i.e. higher compounding. To honour his contrarian legacy, I’d call this BS. I get his point but, in reality, the majority of us would do better by doing something else with our time than studying company filings. If you focus on your career, and dedicate the rest of your time to be sure you do not go into burnout, you will yield higher returns overall than picking stocks / sectors / asset classes / call it as you want. So, thank you Charlie but no thank you.

Then there is the unspoken behavioural component to the diversification experience: we hate owning losers. In relative and absolute terms.

In the last decade, you would have felt like shit if you allocated to anything different from the S&P500. Nick is right and that’s what prompted me to write this post. It is survivorship bias all over again: people that thrived with that strategy smash it to your face every day and you feel stupid.

The lunch might be free but surely tastes like those cruise buffets.

“The biggest downside of diversification: some part of your portfolio is almost always losing money.” In other words, if everything in your portfolio is positive, you are not diversified enough. “Diversification means always having to say you are sorry” observed Brian Portnoy.

And boy, every year you are sorry big time.

Look at the difference between the best and worst performing asset in each year: the average is probably around 25% and it can easily arrive at 40%. The table does not even include crypto or your neighbour’s real estate or wine collection. Plenty of opportunities to bump your head against the wall and feel remorse.

“Even the optimal portfolio loses money” says Nick but the point is not exactly this. When your portfolio gains, you want to match the best of that year; when it loses, you do not care that you are doing better than others, you are sad because you are losing. It is an impossible dream, to outperform and to have no negative years.

Behaviourally, this is linked to loss aversion: the pain we feel with losses is disproportionately large compared to the joy we feel with gains. In the context of diversification, every year is a losing year!

To complicate the matter, we are not wired to see the one portfolio we have; we are wired to see the individual investments that comprise it. Academia calls it the fallacy of composition, practitioners call it “stop looking at the bloody single line item”. We tend to focus on the pieces rather than the whole. In this context, diversification feels RISKIER because we obsess with the asset(s) that is performing poorly and lose the concept of why that asset is included in the portfolio, the alternative scenarios in which it would have worked. Actually, it is working even if there is that red mark.

In risk-off years, we curse at those high-octane assets that are in the portfolio to generate returns. In risk-on years, we cry over defensive positions. Every year, we trash The Italian Leather Sofa who suggested we look at alternative assets.

In a risk parity situation, this is even more aggravated. High-risk assets have low allocations: when one of them loses 30% you do not think “It’s fine, that’s only 3% of the portfolio and therefore represents a 1% loss” but “shit that garbage is down 30%, I am an asshole”.

If something is free, you are the product

“Diversification is a vital concept for investors. It is an acceptance that the future is inherently unknowable and can take many different directions. If done well it provides protection against both uncertainty and hubris.” from here.

Shall we rejoice in the fact that diversification is not free and that’s the best explanation of why it works?

Hubris is the dark side of Munger’s earlier consideration. An investor with a concentrated portfolio might have a harder time admitting themselves they made a mistake because they invested so much time studying and building their portfolio, a sunk cost type of fallacy.

The present we experience is only one of the many possible paths that were presented to us. Diversification is the best way to admit we know nothing…except what we should have done yesterday.

We are trading a strip of short-term pains for a long-term gain. Basically the opposite of those shitty income products and dividend-obsessed charlatans. As Joe says, diversification means actively seeking disappointment in advance.

Leverage

Now, can you really come to this blog and expect not to read about leverage?

Leveraging a portfolio would normally increase (almost) proportionally expected returns and volatility (the “almost” is related to the fact that leverage has a cost that impacts returns and volatility). If you leverage a portfolio that includes more diversifying assets than the benchmark, you increase the probability of generating excess returns relative to said benchmark.

“If you had randomly allocated across stocks, bonds, and trend following and levered that portfolio 1.25x, there is a 95% chance you created positive excess returns versus a 60/40.” from here

The black line represents all the possible combinations of stocks+bonds vs the 60/40. The blue (?) dots are all the possible combinations of stocks+bonds+trend and the green dots are the same portfolios but levered up 1.25x.

Confusing? Yes.

The relevant part is that the green dots move UP, they do not expand up, down and right relative to the blue cloud.

“An intriguing insight emerges when we explore the proportion of positive information ratios. While diversification heightened the likelihood of positive outcomes, leveraging the diversified portfolio significantly amplifies this probability.“

Unfortunately, it all depends on assets that stay uncorrelated and still provide positive returns. If you add a Trend fund that…sucks, or even a fund that correlates too much with stocks because its manager is worried about his tracking error (and consequently his job), this magic is gone.

Diversification issues are amplified when dealing with alternative assets. The line between a stupid investment and an investment that works because everyone else thinks is stupid is very thin. Gold might be the best example for this category. And then some investments work because others think they will, like Bitcoin.

The solution

Focus as much as you can on aggregates: your portfolio or, even better, your net worth (which should be less volatile than the portfolio). Benchmark that aggregates to your goal and your time horizon, rather than that particular year’s best-performing asset.

“A bright side of personal investing is that it is solitaire. You do not need to worry about competitors the way professional investors do. Professionals are compared to benchmarks which introduces tracking error risks (”why are you only up 8% when the SP500 is up 11%?”) and path dependency. Employees are more likely to browse LinkedIn job boards when you don’t keep up, which aggravates your competitive position further.” from here

No one, except yourself, can fire you from your role as manager of your savings. You want to know how are you doing (you should!), so the need for a benchmark. But you should target the right one and try to forget all the rest.

Obviously, I wrote this post because Trend ETFs this year were a total shit show did not perform well. It is the dark side of anything investing (or trading) related, you work (by studying, researching, etc.) only to have less money at the end of the day. Not encouraging. Especially when alternatives suck, because you start to question the manager, the strategy, the alpha. Was it a mirage all along? Was I (again) gullible?

At a certain point this year I started to wish that the stock market would tank, even if that would a be a loss for me, just in the hope that my alternative allocation would rebound. Crazy. Can I fast-forward to the point in the “backtest” where the strategy works again? Unfortunately, this is not how it works.

At least, writing this post is cheaper than therapy.

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