Should or should you not diversify?

How to diversify properly:
Sometimes investors believe they diversify properly when they do not. Diversification is used to moderate market swings by investing in different sectors, countries, asset classes etc. Some sectors are often affected by the same variables or tend to move together through the equity cycle. Currently we are seeing cyclicals such as consumer discretionary and manufacturing as well as financials outperforming. Therefore an investor who would invest in these three sectors would still be greatly affected by the wild cyclical swings of the market. Currently this isn’t so bad, as the cyclical swings tend to be positive…

As diversification serves the purpose of smoothing out the gyrations of the market, a diversified portfolio of cyclicals, for example, would not do the trick. Therefore it is important to diversify across various industries that are not strongly correlated. A basic example would be mixing early cycle companies such as financials and consumer discretionary with utilities and precious metals. This would certainly alleviate some of the effect of sporadic market movements. The most cost efficient way of doing this is to diversify using exchange traded funds for various industries as this way you can take the painstaking effort of actually going out and investing in specific companies. You can also invest through asset classes such as bonds for example, again the easiest way of doing this is through a bond or fixed income exchange traded fund.

The purpose of diversifying is simply to reduce the variability of a portfolio. But what happens when you do not care about variability in a portfolio or that you believe a sector or an asset class is expensive? This brings me to my next point that diversification is not always beneficial.

If you are good, diversification is not:
When you diversify across companies, sectors and asset classes you remove the choice of actually trying to pick the outperformers. For investors who are good stock pickers (or good asset class or sector pickers), diversification often leads to investing in investments at the wrong time and at the wrong price. This means that you are buying bad investments by diversifying.

For example, you own what you consider are the only five stocks that are safe and undervalued. If you want to diversify you might want to buy another 10 to 15 stocks simply to spread the risk in your portfolio. So this basically means that 5 stocks you were fairly sure about have become 25% of your portfolio while the remaining 75% of your portfolio is invested in ‘not so sure’ or overpriced investments. This doesn’t seem very wise…

Warren Buffett has said, “Diversification is protection against ignorance. It makes very little sense to those who know what they are doing”,which highlights my point. If you know what you are doing and understand the companies you invest in, than diversification will only create a  drag your gains down.

By diversifying you are implicitly assuming that you cannot pick the best performers, which is wise if you are not a good investor, but silly if you are. If you want to be safe, diversify, as most people believe they are better than the average at investing, which is a mathematical impossibility.

 If you are a contrarian like me, you might also like 'Why CAPM is useless" and "Why standard deviation isn't a risk measure and bonds are risky".