The Myth of Diversification

diversification eggs in one basket

The following article was written by Adinah Brown, content manager at Leverate.

Every risk management book in every corner of the world propounds the values of diversification. Your financial advisor is probably worrying about the weight of your assets and trying to balance them so that you get a healthy spread of growth stocks, international shares, broad ETF’s, bonds, or some other such thing that allows you to think that your immune from big drops, simply because you now have your eggs in many, many baskets.

And your financial advisor is 100% right. If you had all your eggs in one basket, and someone knocks over your basket, all your eggs are gone!

Diversification’s job is not just to protect you from risk. It seeks to provide higher returns AND lower risk. And this is not a simple process, but rather involves calculating the diversity scores between each asset to find the right correlation and then align this with the investor’s risk/reward profile.

But if you are a professional investor, with an intimate knowledge of the market and what you are trading, is diversification for you?

Let’s stop for a moment to think about applying diversification to life. Think about all the people that have created great wealth, and ask yourself, have they done it through diversification? Every last one of them found something that made them money and kept doing it until they were wealthy. Did Mark Zukerberg decide to switch to teaching Pilates in case his tech work fell through?

Actually, let’s use the Lebron James analogy postulated by none other than Warren Buffett to make this point. He said “If you have Lebron James on your team, don’t take him out of the game just to make room for someone else.”

This is the main point here. If you have an investment that has provided you with strong returns, and you expect will continue to make strong returns, would you take money out of this position to put it in a position that you don’t expect to make the same returns?

It’s telling when you think about the type of analysis that goes into identifying diversified holdings. For your primary holdings, you analyze them because of an expectation of profit. You have reviewed it primarily because of its profit potential. And your diversified holdings? Probably you analyzed the beta or checked that diversity score. Maybe you simply want an ETF in a completely different market sector. Is profit your primary objective here?

You have chosen your primary holdings because you strongly believe that it has profit potential. Your diversified holdings are simply because of the need to balance against the likely profitable holdings.

For someone that isn’t an investor, the profit holdings might not be Lebron James, and so diversification is critical. But an investor invests for profit. Most like volatility, since it gives them the chance to purchase low and plenty of volume to trade.

For someone who knows, and is a quality investor, diversity is the equivalent of taking out Lebron James and replacing him with James Jones (who is not as good a basketball player as Lebron, which is a massive understatement if you know basketball). In this case, diversification goes somewhat against the very raison d’etre of investing.

So if you are in the game of investing, your best play may be to ride Lebron James all the way to the title. Just like Cleveland did in 2016.

(For those who are not fans of basketball, apologies for getting carried away with references that probably make little sense. But since Warren Buffett started it, someone had to finish it.)

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