Abstract
The old saying, “too much of a good thing…” So, it is with diversification. The question is how much is too much? Peter Lynch, in his book One Up on Wall Street, coined the term “diworsification” to describe a company-specific problem: companies investing in areas that were noncore businesses “to diversify” the risk of those businesses. As he, and many others successfully argued, this approach of the 1970s and 1980s conglomerate just made for inefficient companies. They questioned why companies should diversify their investments, when shareholders and investors can do it themselves by diversifying their own portfolios.
The logic holds, but a problem emerges when the portfolio is chopped up, so much so, that it too has become “diworsified”. That is a good place for us to begin, with the question, why don’t investors simply hold the market portfolio, and by market, we mean virtually a piece of every asset in the entire world. The first reason you do not is because you have now become the owner of the best and worst performing assets in equal measure. This is a sure-fire way toward mediocre returns in the portfolio.
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Notes
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Source: Blackrock, as of Jan. 24, 2018.
- 2.
While the Japanese ten year had been at negative interest rates for years, it has recently climbed back above zero, and as of July 2018, was at 0.83%. In that month, the Bank of Japan had shifted its monetary policy (e.g., yield curve control) to target 0% through bond purchases (quantitative easing).
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Benjamin Graham recommended holding 10–30 positions. In today’s world that would be considered a highly concentrated portfolio of a single manager. A properly diversified portfolio in today’s world may contain exposure to a couple thousand underlying holdings, which is not beyond what you would expect when you consider the full measure of all publicly traded securities and private ones, too, both domestic and international.
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Harvey, Campbell R. and Liu, Yan and Zhu, Caroline, “…and the Cross-Section of Expected Returns”, February 3, 2015.
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Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient.
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“2 and 20” refers to the typical fee structure of a hedge fund; 2% for the management fee and 20% of the profits.
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Source: Bloomberg.
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Morningstar Direct.
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Merker, C.K., Peck, S.W. (2019). Over-Diversification. In: The Trustee Governance Guide. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-21088-5_10
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DOI: https://doi.org/10.1007/978-3-030-21088-5_10
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