When Conventional Wisdom Understates The Case

Diversifying your investments is classic advice. If anything, it is underpracticed. This might sound strange but don't worry we will take a closer look at what diversification really means in a future note. The point of this note is to make an even stronger claim than just "I recommend you diversify".

My claim is:

If you do not diversify you are incinerating wealth.


The reason is grounded in theory but better explained via logic. Let's imagine there is a universe of investments that are fairly priced. Nothing offers an unusually attractive prospect of reward compared to risk. Suddenly a new investment opportunity is presented to the world that appears to have especially favorable qualities (extra return, less risk, or low correlation with the market). Let's consider the scenarios:

  1. The potential return above-average + low or average risk → Everyone will buy it. Price will rise until the expected return is driven lower
  2. Extremely high return potential but very high-risk → Investors with large bankrolls who can tolerate the swings will bid up the price
  3. Risk reward commensurate with the market but less correlation → Investors who understand portfolio math will be willing to bid it up driving its expected return lower.

The principles underlying these scenarios, in order:

  1. The merit of any investment can be ruined if you pay too much.
  2. Risk is not an absolute concern. Its suitability depends on the bankroll.
  3. Uncorrelated investments dramatically dampen volatility at the portfolio level.