Diversification is probably best embodied by the old proverb of “Don’t put all your eggs in one basket”, and is one of those phrases that even complete rookies in the financial markets and stock hobbyists know and practice without questioning. As often goes in the markets though, what’s obvious or well-known is rarely useful.
Among the top mistakes that many private individuals make when acting in the stock market, is that they tend to emulate the behavior of large market participants (i.e. mutual-, retirement-, hedge-, insurance funds, trusts, investment banks, etc) when laying out their own strategy or ‘rules of engagement’. Examples of this mirroring are that such individuals have a need to constantly have all their capital in stocks irrespective of market environment, perform valuation-based decision-making, rebalance portfolios, or blindly follow the old trope of diversification.
When it comes to the stock market, there is really no such thing as “investors” – only speculators. For the sake of argument, I will refer to the speculators who do not manage excessively large sums of money (i.e. hundreds of millions or multiple billions of dollars), whether they are professional or amateur/retail, as ‘small’ market participants.
In this article, I’m making the case that in the context of active management, (selection or “picking” of individual stocks in a portfolio), diversification is to a large degree useless to the small market participant. The Pro speculators, who know what they’re doing, are prone to lose their edge using it … the amateurs, who don’t really know how the market works, do not benefit from it materially either.
Never all eggs in one basket …?
Admittedly, the original idiom of not storing all your hen’s produce in one location can be true for two circumstances, and those two only:
One, you are a managing excessive amounts of capital, and cannot exit a single stock quickly without crashing its price – hence you need a way to offset the losses in a single declining equity that you can’t exit quickly by a group of others that (hopefully) trend up.
Two, if you are a small speculator and take excessive risk. By excessive, I do not necessarily mean ‘putting all eggs in one basket’, as there are some Pros skilled in risk control that can do so in exceptionally benign markets and profit handsomely. I mean ‘putting all your eggs in one basket and not controlling risk‘.
The saying is not “truth” per se to anyone participating in the markets … it is “truth” only when applied to the average amateurs who rely on their own sub-standard skill to pick stocks, informed by internet education, forum tips, magazine articles, their own opinion, or other Wall Street idioms.
Opposed to consensus opinion, diversification becomes useless one way or another for the amateur stock picker. As you can read below, as a concept, it is self-defeating in this context.
The average speculator believes he is better than average
The vast majority of people in the market think that they select single stocks better than everybody else. The problem is just that, statistically, if the vast majority of people think they are better stock pickers than the average person, than it follows that the average person thinks that they are better than the average … and by definition, not everybody can be better than the average, much less better than everybody else.
If you were to ‘only’ assume that both the skill of stock-picking and performance of individual stock pickers in the market were following a normal distribution, then half the people would be worse than the average person in stock picking and in market performance. Already in this benign imaginary scenario, by definition, the majority of people would be wrong in their self-assessment, and half of people would under-perform each other and the market.
If only reality was so lenient though! Neither performance in the stock market, nor skill in stock picking, follows a normal distribution.
In fact, reality lies far from it. Even when looking only at professional stock pickers, about 95% of them consistently under-perform the market over a long time-frame. Those are the guys who have buildings filled with research staff at their disposal … and they still can’t even beat an ETF almost all the time. The picture is equally bad for the amateur speculator. This results in a curve that is heavily skewed to the right, i.e. most people are relatively bad in selecting the best stocks (due to various fallacies and mistakes), and even the ones that are better at it have a hard time out-performing the mere market average return.
Of course, more variables than stock picking factor into the final return, but it serves as a quite accurate approximation.
Meet Joe Average, a 30ish hobby “investor” who picked and owns a couple of thousand dollars worth of stocks. A fairly average picture. Joe has learned what he thinks “investing” is by reading one to two run-of-the-mill investment books. He regularly pores over online magazines, financial media outlets, message boards, etc., in the search for another ‘secret sauce’, and avidly believes in the companies he buys stock in. Joe thinks his informed research into companies, his established knowledge and his Wall Street idioms will clearly set him apart from the rest.
Unbeknownst to him, success in the markets is a complex skill that takes years of strategy development, skill-set trial and error, training in emotional discipline and intuition to master. Joe feeling so smug about himself as a stock picker is the epitome of the Dunning-Kruger effect – “low-hanging” fruit knowledge and wisdom, combined with a healthy dose of overconfidence and a very malignant 5% statistical chance of out-performing the market and others become a self-fulfilling prophecy.
In the end, Joe and the vast majority of people that think themselves the best stock pickers actually make up that very majority of people under-performing each other, the market, and even a simple ETF strategy.
For the Pro stock-picker, any diversification leads to reversion to mediocrity
If you actually happen to be part of that 5% that are substantially better than the average stock picker and outperform the market averages consistently, the odds are almost certain that you have learned how the market truly works, are a master of a strategy, are also applying other Pro tactics such as loss-cutting, scaling, pyramiding, exposure capping and -regulation with the market environment, reward/risk considerations, etc. In that case, you don’t need to diversify in the first place – in fact, it will hurt you. Both unnecessary stock-picking-, or index tracking (passive ETF) diversification, will revert your performance down over a long time-frame (see graphic below).
A small market participant that is a Pro in stock picking will always concentrate his money into a small handful of stock picks selected by an elite filtering mechanism, and make major profits from this approach. The more stocks he includes into his portfolio, the more concessions he’ll have to make for their inclusion quality, as his high stringency in selection leads him to only ever focus his money into the 2-8 best stocks in the market. If he forcefully diversifies, i.e. tries to spread his money over more stocks, he’ll have to start compromising his selection/filtering criteria, thereby inviting stocks of lesser quality into his portfolio, and thus their necessarily mediocre performance will dilute the above-average returns of his elite selections eventually back down towards the the performance of less-skilled pickers and the market averages.
For such a speculator, the old “don’t put all eggs in one basked” saying would go more like “put all your eggs into very few baskets and watch the baskets very well” – otherwise the result is diworsification.
For the amateur it may help or hurt … but you won’t know which
The amateur stock-picker has a 95% chance of under-performing the market, and unless you’re seriously bad, more stock-picking diversification will not help you meaningfully (see graphic below).
The vast majority of small market participants, the Joe Averages of this world, are those who believe they are more skilled than the next guy, but in reality often unfortunately even under-perform even the average person, and almost always the market average. Further diversification by stock-picking can statistically only pull them closer to the performance of the average stock picker, which might be better or worse than them – and it’s unlikely that they’ll be able to tell which one.
Thus, they can by definition save a lot of commissions/research subscriptions/etc. and, more importantly time, by just buying and holding ETFs in the ultra long-term, i.e. switch to diversifying via passive indexing, as they are not outperforming the market indices with a 95% chance anyway. For the vast majority, indexing will pull performance up over a long time-frame for such small market participants.
If push comes to shove and stock-picking remains a deep desire, they should let a skilled fund manager do the stock-picking for them (here I explain how to select one).
A hedge against lack of skill
As a rule, I believe amateurs should not concentrate their money into a handful of their darling stocks they’ve picked and ride them through thick and thin (like the vast majority of speculators do). If you are in the stock market at all, either learn how to do it properly, leave it to a Pro, or go with passive indexing. If you are Joe Average and unwilling to learn, there is little point in trying yourself … it’s pure statistics. The odds, consistently acting over the long term, are so that you will either under-perform or just about match the market average performance in the long term, even if you think you will out-perform.
If you truly think about it, for the small market participant, diversification is nothing but the admission of one’s own lack of above-average skill (e.g. in stock picking) and proper risk management. It is done out of an inability to work with high confidence in one’s own abilities in single concentrated marketplaces. Thus, we make room for the eventuality of our chosen “investments” coming back to haunt us. Diversification becomes a hedge against our own lack of skill and risk management.
This is a great admission, as most people who make mistakes try to brush them under the carpet or blame others – a recipe for disaster in the stock market. But if you diversify at all, you have to figure out first whether it is more likely to hurt you by trying harder (i.e. via more stock picking) or help you.
Realize that diversification dampens draw-downs but kills any hope of truly profiting
Large market participants, due to their size, have no choice but to diversify. As a small market participant, you do. Should you choose to diversify, where do you draw the line between what is too much and too little diversification?
When entering this discussion, the topic can quickly become opaque.
As much as single stocks in the market can go down and decrease returns in a portfolio, stocks as an asset class (as opposed to cash, fixed-income securities, commodities such as the precious metal gold, real estate, etc.) can equally under-perform or cause losses over a given amount of time.
Then of course, geographical diversification enters into the equation – foreign currencies, foreign bonds, foreign stocks. Which ones to choose? Developed world only, or do you include developing economies & emerging markets? Which ones, and why? Here again, every small or large speculator will have their own ‘secret sauce’, and here I don’t want to go into the specifics on how to make one.
However, the overarching principle that I want you to focus on is that the more you diversify, the more you again will dilute your overall performance. This often comes at a disappointment to those that want their cake and eat it too – having a perfectly diversified portfolio that brings home few volatility but returns large money quickly.
The two basic ideas behind diversification are that markets/asset classes that are worthwhile to diversify into are those that 1) go up in the ultra-long term (else, why diversify into one?), and that 2) are not correlated to each other, i.e. some “go up” while others “go down”, cancelling out each others volatility. The latter is of course a strong oversimplification, a hope, that has led to momentous losses for amateur speculators.
Putting 1) & 2) together, people diversify into different markets/asset classes to get the overall long-term uptrend while moderating draw-downs/volatility in their portfolio balance caused by losses in any single one.
But on the other side of the coin, there is the fact that the more markets/asset classes you diversify into, as for single stock picking, the more you will pull the sum of their performances into a more and more mediocre and lacklustre uptrend – this is just statistics.
If you select 1 asset class and spend time on truly learning how to out-perform with it, you have at least a chance of right of the average, i.e. a chance of outperforming. Of course, you might also be bad at it, and under-perform. If you select 10, 20 or more asset classes, the more you will approach the average, and the average of every known asset class becomes a sad and very very small performance in the long term – but it will be a more likely one. You end up being the Jack of all trades, but master of none – which is ok for some people, but you need to know where you stand.
The crux is as follows:
Common advice for choosing the degree of diversification is to find a level of “risk” you’re comfortable with. But the vast majority of people (the equivalent of the above skill curve would apply) are not skilled macro-investors such as Ray Dalio, and it is out of their sphere of competence to judge or ballpark what “risk” really is in the context of diversification, and how to optimize it and select a degree of risk that will yield results that fit them personally (their “risk appetite”). It is just too complex a field, and an amateur is highly liable to end up making the wrong decisions again, even when it comes to picking vehicles for diversification.
You either spend few to no time understanding how investing works, diversify as widely as possible without trying to “pick”, and are happy with little returns, or you spend a lot of effort on it, become great at it, focus & concentrate your money and reap better rewards. There is no middle ground, as even for diversification (as it does for stock picking), limited skill has a high chance of only making your performance worse. There is a reason why the best money managers in the world either focus on one asset class and become the best in their arena, or focus on diversified portfolios and take the ultra-long term approach. Dabbling is not an option.
Thus, even the choice of diversification should be either a set-it-and-forget it approach of very wide diversification (without “picking”, across international stocks, bonds, REITs, commodities) or no diversification at all and learning how to properly invest/speculate in one asset class/marketplace with skill and stringent risk management. As a small amateur market participant, don’t try to pick vehicles based on your own opinion or limited skill.
For both stock pickers and diversification-vehicle pickers, that which you don’t know that you don’t know, and that which you know that ain’t so, is what will hurt you.
Concluding
Unless you truly know know what your’re doing, odds are against you – you’re better off staying away from stock picking at all, and so the need for diversification in your picks does not exist. If you know what you’re doing, you don’t need diversification, as it dilutes your skill. If you are a large market participant managing billions of dollars, you have no choice other than to employ it.
Those that are not willing to put up the time/effort to become a pro speculator, hand your money to a truly skilled money manager, or use ETFs in an ultra-long term approach. You may diversify, but remember – the more you do, the less returns you’ll chalk up. This might work for capital conservation for those that already have a lump sum of money, and want to preserve/hedge it against inflation or certain market or geopolitical risks. However, if it is money growth in a short time frame you’re after, diversification-dilution does not work in your favor. In that case, you might be better off to make your money elsewhere, e.g. opening a business.
The more you diversify, the more you enter a zone of moderated draw-downs, but also increasingly give up any chance of truly making money.
For large market participants, diversification is a hedge against their own size (and lack of skill). For small market participants, it’s a hedge against lack of skill.
Concluding, diversification for the small market participant only makes sense:
- as a non-picking fully unsupervised, passive, wide approach (such as ETF indexing over stock picking, buying a gold ETF or physical gold over gold stocks, buying REITs over investing in single properties, etc.) across asset classes,
- over the very long-term (many years to decades),
- accepting that increasing diversification leads to increasingly moderated draw-downs but also precludes achieving what one might call “Big Money”.
Should you however want to take matters into your own hands and learn how to become part of the 5% that can outperforming stock pickers, sign up for my stock speculation package and you won’t have to bother with diversification.
