When Diversification Fails

Diversification means different things in different contexts.  We can speak, for example, of diversification within an equity portfolio — i.e., of holding a number of stocks with potentially-offsetting risks, as opposed to concentrating on only one issue or on a handful of similar stocks.  Or we can think of diversification across asset classes — e.g., by adding bonds, or international stocks, or commodities to a (diversified) U.S. equity portfolio.  Conventional wisdom smiles on these two forms of diversification, and rightly so, since the final diversified portfolio typically has a higher expected return, or lower expected risk, than the starting portfolio.

But diversification might not always be a good idea.  Suppose I go a casino, find the roulette wheel, and bet on a number at random.  I’m likely to lose my money.  If I do the same thing a second time, and a third, the result is likely to be the same.  I haven’t created a diversified portfolio of bets — I’ve merely repeated the same mistake several times over.

A recent white paper asks whether the selection of active investment managers is a useful or fruitless form of diversification.  (Spoiler alert: fruitless.)  Why?  Active managers, more often than not, underperform the indices against which they’re benchmarked.  An investor who chooses an actively-managed fund over an index fund is therefore more likely than not to underperform.  Adding a second and third actively-managed fund is likely to leave the investor worse off than he was with only one (just as multiple turns at the roulette wheel are likely to leave a gambler poorer than he was after his first bet).

If it were easy to find outperforming active funds, diversifying active management might be beneficial.  But it’s not easy — and that implies, as discussed here, that picking active managers is one of those areas where diversification fails.

The posts on this blog are opinions, not advice. Please read our disclaimers.

One thought on “When Diversification Fails

  1. Pingback: The Fox and the Hedgehog | S&P Dow Jones Indices

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