Value Investing: Tools and Techniques for Intelligent Investment

Chapter 4. The Dangers of Diversification and Evils of the Relative Performance Derby^[4]

If religion has been the cause of most wars, then 'diversification' lies close to the heart of many financial disasters. All too often, too narrow a perspective is taken when thinking about diversification. Investors appear to forget that risk is endogenous (like poker) rather than exogenous (like roulette). In the equity world, diversification is often taken to the other extreme. The average US mutual fund holds anywhere between 100 and 160 stocks! The only explanation for so many holdings must be the obsession with the relative performance derby (where tracking error is all that matters). This is one of the key sources of poor performance.

• Much damage in the world of finance has been committed in the name of diversification. For instance, LTCM thought it was 'diversified' but all its positions were effectively 'convergence' trades. Modern risk management seems to have embedded similar flaws into its structure. All too often, the use of short histories of trailing data provides the illusion of safety.

• The most recent crisis once again has the fingerprints of naïve diversification all over it. No one appeared to give any thought to the unspoken risk that the USA might just witness a nationwide housing market downturn. Greenspan observed that real estate was 'especially ill-suited to develop into a bubble', blatantly ignoring the evidence provided by Japan and the UK.

• In the wonderful world of equities, ...