The Diversification Sham
It seems like everywhere you turn people are telling you to diversify. They say you should always be spreading your investment amongst a variety of picks in order to ensure that you hedge your losses. Have you ever watched someone play roulette at the casino? The better is laying down chips all over the board hoping that one of them will hit big enough to cover the losses of the others. This often happens with venture capital investors as well – they invest in a variety of companies from seemingly every industry and hope that one of them will be their next “Facebook” or “Twitter” and they will cash in big to cover the losses from their other investments.
This is a common strategy among entrepreneurs as well. They will diversify their time and put it all over the place, into a variety of initiatives, hoping that one of them will pan out. Unfortunately they, sometimes, end up getting spread to thin and nothing works out. And you’ll notice the Dragons and Sharks are always looking for the desperate and hungry entrepreneur that has put all of his coins in one bucket – but wait, this isn’t diversification for the entrepreneur is it? It surely is for the Dragons and Sharks as they pick up a variety of investments. But then on the other hand there is a whole subculture of entrepreneurs that continue to keep cranking out success after success story while running them all parallel. This starts to bridge on conversations around time management, Pareto Efficiency economics, and even natural innate abilities. Take a look at something called Low Latent Inhibitions and you may be quite surprised that people like this exist.
The point I’m getting to is that any way that you cut it, the strategy of diversification is always based around some sort of hedge. Betting on a large amount of things in hopes that one works out and saves you from the other failures. The problem with this is after things are averaged out, you only obtain mediocre returns. The Central Limit Theorem states that as the sample size increases, the closer the distribution comes to being “normal”. Here is a quick little explanation that my pal Salman Khan has thrown up on Khan Academy:
But who wants just mediocre returns? You might as well throw your money into an ETF or a Mutual fund that just tracks the market. Not only will you get average returns but you’ll also be poorly protected against anomalies in the market in hopes of retaining and protecting your wealth. This is where value investors thrive.
As generalist value investors, we’ve noticed that the diversification sideshow is exactly that. It’s a sham. Sure, there are a variety of reason why a value fund is successful but one of them is most definitely because assets aren’t diversified based on their industry classifications. Let me be clear. The assets aren’t diversified but their outcomes are. This is where the distinction lies. We take a meaningful amount of money and invest it into assets that are well research, undervalued and very, very, understandable. As a result, we aren’t seeking companies that play in various markets simply for the purpose of diversifying. We follow a bottom-up approach and pick great companies with sustainable economic moats that are bound for success. That being said, during the portfolio management process we look at the factors that affect the outcome of our investments. This is where we “diversify”. It would be useless to have an entire portfolio based around the success of the cattle industry or the petroleum market, to name a few. Here is an example: your average investor may buy shares in a computer hardware company and a company doing business in IoT (Internet of Things) and claim diversification. But guess what… they are both affected but the costs of SMT (surface mounted technology – chip boards). What about buying shares in an automotive company and an oil company? Though one may be consumer discretionary and the other maybe energy/mining, their successes are still based around petroleum prices. Diversification doesn’t exist in this case.
To summarize, take your time. Research your investments. Make valuable, educated and confident decisions with a meaningful amount of money. And when choosing your portfolio, make sure you diversify and spread your assets based on the outcomes and not the medians. Spreading out in medians (whether it is with money, time, or entrepreneurial goals) is what the world knows as diversification and it’s what brings mediocre results, is counterproductive, and isn’t a successful value strategy. Stick to outcomes.