Cognitively Yours 1.10

 

Raja R, Author

"Diversification is an admission of not knowing what to do, and our effort will be to strike the average - Better a steady dime, rather than a rare dollar"

In the previous blogs, we discussed how mental shortcuts though needed to take quick decisions do induce us to make errors in investing. In the last blog, how emotional reactions often drive our behaviour.

"let every man divide his money into three parts and invest a third in land, a third in business and a third let him keep in reserve" - Talmud 1200 BC - 500 AD

Quite aside from financial forms of risk management, merchants learned early on to employ diversification to spread their risks. Antonio, Shakespeare’s merchant of Venice, followed this practice:

My ventures are not in one bottom trusted, nor to one place, nor is my whole estate, upon the fortune of this present year, Therefore, my merchandise makes me not sad. (Act I, Scene I).

For most investors, the hardest part is not figuring out the optimal investment policy, but for staying committed to sound investment policy through bull and bearish markets and maintaining what Disraeli called “constancy to purpose”. Sustaining a long-term focus at market highs or market lows is notoriously difficult. Destination is very much important but equally important is the journey to destination. If the journey to the destination is a roller-coaster ride, chances are that you will abandon the journey mid-way and not reach your destination. If the journey to your financial destination is turbulent and tumultuous; diversification smoothens it, to make the journey more pleasant.

Why diversification?

Diversification is both observed and sensible. A rule of behaviour which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim. The behaviour of a system that consist of only a few parts that interact strongly will be unpredictable. With such a system you can make a fortune or lose all your fortunes with one big bet. In a diversified portfolio, by contrast, some assets will be rising in price, even when other assets are falling in price; at the very least, the rate of returns among the assets will differ. The use of diversification to reduce the volatility appeals to everyone’s natural risk averse preference for certain rather than uncertain outcomes. Most investors choose the lower expected return on a diversified portfolio instead of betting the ranch, even when, the riskier bet might have a chance of generating a larger pay off - if it pans out.

Diversification and theory of games

There is a close resemblance between diversification and games of strategy. As in theory of games, one player is an investor and the other player is the stock market - a powerful player and who is very secretive about its intentions. Playing to win against such an opponent is likely to be a sure recipe for losing. By making the best of a bad bargain - by diversifying instead of striving to make a killing, the investor at least maximises the probability of survival.

Is variety in manager style true diversification?

Often investors consider variety as diversification. This is a classical example of “1/n strategy”- dividing one’s investments evenly across various investment options available. The proportion invested in each investment option depends on the number of choices available. If there are three choices - say three NFOs on tap, the investor will split his investments equally among the three choices. This is naïve diversification. Depending on how the choices are structured, individuals can end up taking too little or excessive risk. Investors tend to misinterpret variety for diversification and pick many different kinds of funds as a result. Thus, by offering a variety of styles, flavors and colors, the mutual fund industry capitalizes on this behavioral pattern. Diversification is not just holding many different things. Diversification is effective only if the portfolio holdings can be counted on to respond differently to a given development in the environment.

Keynes had a different view on diversification "I am in favour of having as large a unit as market conditions will allow. To suppose that safety first consists in having a small gamble in a large number of different companies; where I do not have any information to reach a good judgement. As compared with substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy."

Perhaps, put all eggs in one basket which you can manage rather than put in different baskets which you cannot manage or monitor. Once you obtain confidence, diversification is undesirable.

Diversification is an admission of not knowing what to do, and our effort will be to strike the average. “Better a steady dime, rather than a rare dollar”."The only true wisdom is in knowing you know nothing." Socratic paradox sums up diversification.

Diversification and the Gestalt philosophy - "The whole is greater than the sum of its parts."

Designing an optimal portfolio is no different than creating a good meal. As you will learn, both are largely dependent on ingredients (investments) and recipes (methods). It seems to us that the more important thing in the kitchen isn't having the best individual ingredients — though obviously that helps. Rather, the magic of a great meal is how you combine the ingredients. Similarly, great portfolios are not so much the result of superb individual securities, but rather from putting together securities that are mutually complementary.

By diversification, will all the assets do well and qualify for "Man of the Match"?.

If you have a truly diversified portfolio, then you guarantee yourself - by definition – "that some of your assets will do well while some others will do badly". If you regard risk as the probability of experiencing some loss somewhere in any given time period, then a diversified portfolio will be perceived riskier than a single concentrated investment. But, this is not what risk should mean to one - don’t go looking for losses one by one.

The one important thing one should keep on mind regarding "Diversification" is the notion that one should be interested in risk as well as return. The reason people do not put all their eggs in one basket is that they would run the risk of being wiped-out if the basket dropped or got damaged. Risk means that more things can happen than will happen. We do not expect that our house will burn or car meets with an accident, but it might. So we insure against the risk of fire or accident. We do not expect the stock in which we invest to decline in price, but it might. So, we do not put all our money into one stock. Most of us are naturally risk-averse. We prefer known outcomes to uncertainty, no matter how confident we may be of our stock picking skills and our eagerness to see our wealth appreciate. We know that nothing will be gained if nothing is ventured but we know that the venture involves the risk of loss. In a bullish market, when one sector is hot, diversifying your money across other assets will always feel like a waste of effort - an umbrella you never seem to need, on a sunny morning in Mumbai during the monsoon months. No matter how many times you carry an umbrella without needing it, you will be very glad ,indeed, to be carrying one when a downpour finally hits.

In short, It’s human tendency to prefer to be approximately right than exactly wrong. Diversification is often called "the only free lunch" in investing because it can reduce risk without dramatically reducing returns.

Reference: Beyond greed and fear by Hersh Shefrin, Your Money Your brain Jason Zweig, Against the Gods by Perter Bernstein

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