Diversification, or the reduction of non-market risk by investing in a variety of assets, is one of the hallmarks of traditional approaches to investing. What is less appreciated, however, are the ways in which it makes emotional as well as economic sense not to have all of your eggs in one basket. As is so often the case, the poets, philosophers and aesthetes beat the mathematicians to understanding this basic tenet of emotional self-regulation. The Bible mentions the benefits of diversification as a risk management technique in Ecclesiastes, a book estimated to have been written roughly 935 BC. It reads:
“But divide your investments among many places,
for you do not know what risks might lie ahead.”
- Ecclesiastes 11:2
The Talmud too references an early form of diversification, the prescription there being too split one’s assets into three parts – one third in business, another third in currency and the final third in real estate.
The most famous, and perhaps most eloquent, early mention of diversification is found in Shakespeare’s, “The Merchant of Venice”, where we read:
“My ventures are not in one bottom trusted,
Nor to one place, nor is my whole estate
Upon the fortune of this present year:
Therefore, my merchandise makes me not sad.”
It is interesting to note how these early mentions of diversification focus as much on human psychology as they do the economic benefits of diversification, for investing broadly is as much about managing fear and uncertainty as it is making money.
Brought to the forefront by Harry Markowitz in the 1950’s, diversification across a number of asset classes reduced volatility and the impact of what is known as “variance drain.” Variance drain sounds heady, but in a nutshell, it refers to the detrimental effects of compounding wealth off of low lows when investing in a highly volatile manner. Even when arithmetic means are the same, the impact on accumulated wealth can be dramatic.
Say you invest $100,000 each in two products that both average ten percent returns per year, one with great volatility and the other with managed volatility. The managed volatility money rises 10% for each of two years, yielding a final result of $121,000. The more volatile investment returns -20% in year one and a whopping 40% in year two, also resulting in a similar 10% average yearly gain. The good news is that you can brag to your golf buddies about having achieved a 40% return – you are an investment wizard! The bad news, however, is that your investment will sit at a mere $112,000, fully $9,000 less than your investment in the less volatile investment since your gains compounded off of lower lows.
Managing variance drain is important, but a second, more important benefit of diversification is that it constrains bad behavior. As we’ve said on many occasions, the average equity investor lags the returns of the equity market significantly. It is simply hard to overstate the wealth destroying impact of volatility-borne irrationality. The behavioral implication of volatile holdings is that the ride is harder to bear for loss-averse investors (yes, that means you).
As volatility increases, so too does the chance of a paper loss which is likely to decrease holding periods and increase trading behavior, both of which are correlated with decreased returns. Warren Buffett’s first rule of investing is to never lose money. His second rule? Never forget the first rule. The Oracle of Omaha understands both the financial and behavioral ruin that come from taking oversized risk, and more importantly, the power of winning by not losing.