Portfolio Strategy: Avoid Diworsification

alphadawgg Fri Aug 15, 2008 2:07pm EST 13 Comments

I initially encountered the word “diworsification”, in Peter Lynch’s book, “One Up on Wall Street“. As you may surmise, this is a play on the word, “diversification”. Is it possible that you can be “too diversified” to the pont that your investment account is actually worse off? Let’s talk about this…

Diversification is standard verbage for the investment community. “You need to lower your risk through diversification“. “Have you diversified your portfolio, Mr. Client/Investor”? And every brokers favorite, “I think if you need to add a fourteenth mutual fund to your portfolio—you know, for more diversification“.

This time honored idea of diversification, on the surface, seems quite prudent. “Don’t put all your eggs in one basket”, grandpa used to always say. Sound advice….. Or, is it?

All this focus on diversification stems from the idea of staying with conventional investment wisdom, much of which is based on the “efficient market hypothesis“. In addition, the concept of diversification also helps Wall Street firms sell more mutual funds. The more asset classes, the more mutual funds needed. Great marketing.

But let’s get back to this “efficient markets hypothesis” thing. For those of you who are unfamiliar, this theory argues that investment performance will generally track the market. It doesn’t matter how you invest, how you pick stocks, etc…over the long haul, you will achieve market-like returns. So why beat your head against the wall trying to come up with great stock ideas? And all those charts and graphs? Technical analysis? Rubbish. Throw it all in the dumpster. You are relegated to the returns of the market. Sorry. So, why even bother with iBC?

Proponents of this theory (mainly academics and John Bogle), will always cite statistics like, “In any given year, 80% of mutual fund managers fail to outperform the market”, blah, blah, blah. This is how the Vanguard Funds became so popular with Joe “Asshat” Investor.

The reason managers fail to outperform the market, we are so kindly told, is that all information is already “priced in” the value of company stocks. Therefore, in the (misguided) opinion of the efficient market “asshats”, it’s difficult to outperform the market. Nearly impossible. Can’t be done.

What they don’t tell us is that the theory also presumes that investors act rationally and make logical decisions based on all the information that is already out there. Supposedly. Uh-huh.

If you are one to subscribe to this idea, then you only need to invest in asset classes — stocks, bonds, cash, and lately, commodities, and the market will take care of the rest. Cancel your expensive subscription to iBankCoin.

They’ve even made it fancier for us by adding in sub-asset classes like “large cap growth”, “large cap value”, “mid cap blend”, etc. ,etc. etc. More mutual funds to create and sell.

Remember, you are being prudent. You are diversifying, right?

Question: Why only have ten or twelve stocks when you can be more diversified via an S&P Index fund that has over 500 stocks in it? Isn’t it better to be more diversified? Answer: Case in point…. March 2000 – July 2008. How’s that S&P index fund treatin’ ya? What? You’re still underwater? Egregious.

Here’s my take on all this:

The broad, conventional acceptance of diversification, spawned by the efficient market theory, has been overpromoted, sliced, diced, and fed to the masses by Wall Street. And it is erroneous.