HUMMONEY - Increasing Risk Through Diversification (Perspective)

by Greg Lewin

I have been a professional investor since 1982 and I thought it may be useful to pass along an early observation which greatly influenced my thinking. I was reading an article by an economist from MIT published in the early 1980’s which examined theories of stock market diversification. He concluded that when holding a diversified selection of 10 stocks you achieved over 90% of the benefits of portfolio diversification. Additionally, as you grew the number of stocks held beyond 10, those benefits diminished rapidly. A second important insight provided by this particular study helped reorient my thinking. The author then went on to point out that another fundamental characteristic of a diversification portfolio is that it will perform increasingly like the underlying asset it was designed around. Therefore, a portfolio of 10 diversified stocks will be highly correlated to the actions of the stock market itself. In other words, with 10 or more large stocks in hand you will act and feel a lot like the market in general.  

Now this influences some very fundamental thinking when managing financial assets. First, diversification is most probably the primary tool advertised by financial advisors to manage risk. So given what we just learned, if I, for example, were to postulate that the stock market was to decline 50% would you be managing your risk if you were essentially mimicking the stock market? I think the answer is clear. Diversification across asset classes - a house, gold, bonds, commodities, art, stocks, etc. - is much more relevant as a risk management tool versus diversification within the stock market. Although I will offer that over the years the correlation among asset classes is increasing super fast and thus this form of diversification may also prove less valuable in reducing risk.

My position is not to totally squash this concept, rather, to put it in better context when analyzing advice and strategies. First of all, I would like to think my advisors have thought things through rather than just regurgitating finance 101, when in fact this could lead to some pretty sobering consequences if markets fall. Second, it should help explain why most money managers perform similarly to the overall stock market, but trail miserably when fees, expenses and taxes are included. Diversification can actually be a bit of a ball and chain. However, I believe many advisors and money managers intentionally use diversification strategies to ensure they never really deviate from the crowd. This has always been a reliable way to keep your job. I am just not sure why it should help you keep your client? We may now know why such luminaries as Warren Buffet have been the biggest advocates of undiversified portfolio thinking.   

The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.