In 1996, Warren Buffet famously said “Diversification is a protection against ignorance, it makes little sense if you know what you are doing.” Regretfully, this quote is often used by retail investors to dismiss the benefits of diversification without truly understanding how it works.
To understand diversification, investors must understand three concepts from a financial markets perspective: risk, expected return, and the risk-return relationship.
First, the risk of an individual asset consists of systematic risk and unsystematic risk, which is undiversifiable and diversifiable respectively. Together, the total risk measures how likely actual returns will be different from expected returns.
Second, expected returns is an estimate of the return any asset will generate. This includes a risk free rate of return typically measured as yield on government bonds, and additional return incremental to the risk free return for taking risk.
Finally, the market requires greater expected returns for greater risk. However, since investors can allocate money to an unlimited number of assets in a portfolio, investors are only awarded expected return for taking on undiversifiable risk. The implication of this is clear: an undiversified portfolio is not optimal.
Undiversified is nonoptimal
In an undiversified portfolio, investors are taking on unnecessary (diversifiable) risk for the portfolio’s level of expected return. When done correctly, diversification can reduce risk for the level of expected return sought, or increase expected returns at the same amount of risk taken with no cost to the investor.
Diversification is free
Unfortunately however, many investors have a common misconception that diversification costs returns, often bring up two common invalid points to support their belief.
The first point is that one can achieve better returns by only investing in the best performing stocks. When one stock outperforms the rest in a portfolio, it is understandable some investors would mistakenly conclude that diversification costs return. However, it is not valid to compare actual returns to hypothetically returns of investing in one stock instead of a portfolio. In fact, this is an example of hindsight bias: investors convinced themselves they predicted the outperformance of a stock only after the fact.
The second point is that the traditional 60/40 stock bond diversified portfolio underperforms the stock market. While this fact is correct, the underperformance is driven by the differing expected returns of stocks and bonds, not due to diversification. To demonstrate simplistically how diversification can reduce risk, refer to the table below.
Example A | context A(50%) | context B(50%) | Expected Return |
Asset A | +150% | -100% | +50% |
Asset B | -100% | +150% | +50% |
Equal Allocation (50%A and 50%B) | +50% | +50% | +50% |
There are two investing environments and two assets. Each environment has a 50% probability of happening, in which one asset will produce an 150% return and the other asset will produce an 100% loss. In this example, investing in both assets eliminates the possibility of loss and maintains the expected return. In practice, although the possibility of loss cannot be eliminated, it can be greatly reduced.
Beware of Survivor’s Bias
Another invalid point that is sometimes brought up are anecdotal examples of investors achieving extraordinary returns with one stock. However, this fails to take into account that investors can also incur massive losses. For example, Jeff Bezos and Bill Gates were both start-up founders that generated exceptional returns for themselves with their wealth concentrated in one asset (their respective companies). However, there are infinitely more start-up founders that fail than there are those who become successful. Investors should not dismiss the risk of massive losses, up to 100% of their investment. The success of the few that invested their wealth in a single asset are often celebrated, but the failure of many that did the same will rarely be discussed.
Types of risk and how diversification protects against them
The below table is a framework on the four types of risks: certainties, informed uncertainties, unconscious assumptions, and unforeseen events.
Certain | Uncertain | |
Aware | Certainties | Informed Uncertainties |
Unaware | Unconscious Assumptions | Unforeseen |
In practice, diversification protects against three things, incorrect judgement, ignorance, and uncertainty.
No one is always right
Investors judge events they are aware of as certainties or informed uncertainties. However, judgements can be wrong. For example, retail sales go up during the holidays because of gifting: this statement is a certainty because investors are aware of this and judge it to be true. In many cases, the markets agree with that, and asset prices reflect it. However, certainties can be wrong. For instance, if a recession happens in the middle of the year, it is possible holiday retail sales won’t increase as expected. The same dynamic applies with informed uncertainties. For example, when Apple launched the iPhone, most investors, as well as the market, knew that it is possible that Apple could take market share from other cell phone manufacturers, but gave it a low probability of taking substantial market share. Of course, Apple proceeded to take significant market share from other cell phone manufacturers. In turn, investments in the manufacturers that lost significant market share lost significant value. Good judgement is being right more often than wrong, diversification is protection when investors are wrong.
Uncertain outcomes
In addition to being wrong, multiple outcomes are possible in any uncertainties. For example, the amount of snow New York will receive in the coming year is an informed uncertainty. While a prediction can be made using historical data, the actual outcome can vary greatly. And if an investor’s capital is invested only in a hypothetical New York state snow shovelling business, it is going to be a bad year if it is significantly warmer than normal. This also applies for unforeseen events, of which most investors and markets are neither aware nor certain. COVID-19, 2008 Financial Crisis, 9/11, and other major events falls under this category. In the case of COVID-19, the differences in sector performance are staggering, and diversifying can help you protect against adverse outcomes.
Ignorance is not bliss
While unforeseen events were previously discussed, unconscious assumptions are another type of ignorance that can be just as dangerous. For example, records were once the predominant way of listening to music, until cassettes were invented. Then, as technology continued to evolve, CDs, then MP3 players, and finally phones became what most people use to listen to music. During times when prevailing technologies are dominant and new ones were not yet introduced, investors rarely entertain the possibility of dramatic change in an industry. As a result, investors, some of which incurring significant losses, are often caught by surprise. To mitigate ignorances, diligent investors will continuously seek to learn and increase their knowledge base. However, since it is impossible to know everything, investors should diversify to protecting against their own ignorances.
Diversification Tools
Incorrect judgements, ignorances, and uncertainty manifest in countless ways in the investing world. To diversify well, investors should think hard about risks in their investments to mitigate or neutralize them while taking into consideration expected returns. While for the average person, a low cost S&P500 passive ETF will provide sufficient diversification and sufficient returns. However, investors that aim to be more specific have access to various tools for diversification.
Diversification Type | Risk Mitigation Intent | Tool |
Competition | Between companies in an industry | sector ETFs / manually pick |
Industry | Between industries | multiple sector ETFs |
Geographic | Between geographic regions | multiple country and region ETFs |
Asset Class | Between asset classes | multiple asset class ETFs |
Strategy | Between various strategies (size, quality, growth, value, dividend) | multiple strategy ETFs |
Diversification is an optimization
Diversification is an optimization, it does not happen in isolation. Too often investors make the mistake of investing in an asset only for diversification. This is backwards: diversification is a means to an end, not an end in itself. Investors must first have clear return, risk, and other investment objectives. Only then, should investors move on to asset selection and capital allocation to form the portfolio. Putting it simply, the role of diversification is to optimize the expected return versus risk relationship.
Limits to diversification
While the only theoretical limit to the benefit of diversification is the complete elimination of diversifiable risk. For each asset investors hold beyond 20 uncorrelated stocks, the marginal benefit of diversification decreases. Furthermore, there are the two practical limits of diversification: number of assets worth investing in, and the amount of time and energy an investor has.
While the number of assets in the investment universe should satisfy investor expected return, risk, diversification, and other objectives. The number of companies, strategies, and asset classes investors have access to and is worth investing in is not infinite. For example, most retail investors have limited access to IPOs, venture capital, and hedge fund investments. Furthermore, as investors gather and rank their list of potential investments, the further down they go, the less likely that investment is to outperform. Again, diversification is an optimization, not an end.
Doing due diligence on a potential investment takes time and energy. And since neither is infinite, the number of companies an investor can consider is not infinite. Worse, if an investor is not thorough, because there is so much to learn and keep up with, it could be a breeding ground for mistakes.
Long live diversification
While the famous 1996 Warren Buffet quote is valid, everyone has ignorances, everyone makes mistakes, and most things in life are uncertain: even if they know what they are doing. Now, most people that push this quote also neglect to mention that Buffet recommends a diversified low cost S&P500 index fund for most people. In fact, in 2007 Warren Buffet bet Protégé Partners LLC $1 Million that an index fund would outperform their hedge fund over a 10 year period, and won. For the active investors, here is the take away: diversify in line with investment objectives, as much as reasonably possible, and as an optimization rather than for its own sake.