Diversification is just lazy!

J. William Smith By J. William Smith
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on June 08, 2012 at 8:18 AM, updated June 08, 2012 at 8:30 AM


Diversification is almost compulsory when an investment manager advises.  Investment managers push their training about diversification onto their clients for two reasons.  But before we uncover those reasons lets examine what is investment diversification and why is it heavily pushed on investment clients? 

Well, diversification is choosing of several stocks that represent several companies over different industries and company size.  Diversification often includes billion dollar companies and smaller ones.  It may include tech companies, health care companies, oil companies, and companies from a number of other industries.  So basically, diversification is spreading the risk around.  It is done because it keeps the average investor from losing all their money just in case one company decides to go the way of Enron.  First, money managers push diversification because it is easy to justify to a client that he or she has done their best job of spreading risk around. Second, they are pushed onto clients because some managers receive commissions for selling mutual funds. 

Yet, the sad truth is that diversification does not work.  In recent years, we see more and more intertwined market behavior.  Even before that, the risk of losing everything on one company was greatly exaggerated especially if that company had strong financials and regularly paid dividends.  But, the fear of being a part of the next Enron is stronger than the reality. Therefore, we have made several mistakes and will pay for it with our money.

  • · Investment accounts are treated like savings accounts.  In the mist of the craze and newfound popularity of the stock market we forgot that the stock market is not a savings account.  We were taught to assume that your money could be safe if we picked the right stocks, diversified enough, or had the right investment advisor. The true is that the stock market is investing and it's a risk.  You should approach investing with the same risk and concern as opening a restaurant in New York City.    

· Today's money managers utilize top down investment models.  One is quoted as saying: "I build portfolios from the top down going sector by sector. Before stocks are selected, decisions are made about overweighting or underweighting the sectors and then what countries to buy.  Top down theory says that stock selection is the least important part of the process..." - Roger Nusbaum.  Nowhere else are investment made without having the slightest understanding as to their profitability. 

I leave you with an analogy: "When I was a senior in high school, everyone fretted about what college they'd get into, and agonized over the best application strategy. Some students filled out just a few applications, but worked long hours to make sure they were perfect: Neatly-typewritten forms, carefully-crafted essays--the whole bit. Other students took a different approach. They feverishly sent out applications to 10 or even 15 good colleges. With so many applications to complete, they lacked the time to ensure that every one was polished, but by spreading their bets around they hoped that some admissions officer, somewhere, would give them the nod."[1]