We are currently revising and updating this Whitepaper. Please check back soon.
In the meantime, we have summarized the basic framework for our approach to Diversification:
1. Diversification is how investors keep from putting all of their eggs in one basket. It is the logical response to the possibility of having an entire investment portfolio damaged or destroyed by a single event
2. There’s a right way and a wrong way to think about and execute diversification
3. The wrong way is illustrated by the notion, “I will buy a little bit of a lot of things and hope that at least some of it works out in my favor.”
4. An investment portfolio is just like any other engineered thing: if proper functioning is important, then the parts you build it with matter
5. The right way to diversify starts with identifying what the investments need to do for the portfolio, in terms of its overarching goals (growth, income at x%, etc); then finding specific investments which come as close as possible to serving the needed functions
6. Investors who take the time to develop an understanding of what should happen with the investment, if everything goes well, are in a much better position to pick assets and execute diversification which will work properly
7. The investor’s thesis on what the investment should do is what justifies its acquisition. The fact that sometimes things don’t go as planned is what makes diversification necessary. These two points define an approach which is the logical response to the reality of investment uncertainty, and is very different than operating on the basis of buy-and-hope.
Diversification is the design feature which covers the gap between what should work and what does work. Diversification is not a lottery ticket or a replacement for analysis and projection, but a thoughtful acknowledgment that sometimes things don’t go as planned.
See Notes below for comments on implementation.
See our Model Portfolio for an example of the above principles.
Notes:
1. There are two divisions within the portfolio: Diversification among asset classes; then further diversification among investments which fit under each class heading
2. Having too few allocations leads to over-concentration of risk. But having too many leads to administrative problems and a diminished ability to pay enough attention to each one. So there’s a Goldilocks zone, both at the class level and at the constituent level.
3. Another consideration is what the investment’s loss-profile looks like. Some things may fluctuate up and down in price, but will essentially always have some intrinsic value (e.g. gold, barrel of oil, farmland, etc). Others can lose all of their value (e.g. stock in a single company, an unsecured loan to a business owner, etc). If investing in things which can “go to zero” then having more allocations is probably indicated. Then again, if you can get a similar return from a different asset with the other kind of profile, you face a difficult question: Why accept the risk exposure of investing in something which can lose all of its value in the first place, if a suitable alternative is available?
4. An awful lot of poor investments have been made over the years by people who attempted to explain away the decision by saying, “Well, I was just trying to get a little diversification.” Buying junk isn’t investing, nor is it diversifying. It’s just making a bad decision with a big price tag.
5. If you don’t have a reasonable expectation of positive results which are in line with what you need that block of capital to contribute to the portfolio’s overall return, the case for saying ‘no’ to that investment is stronger than the case for saying ‘yes.’