Diworsification

Was investment diversification good or bad? Shimshi Korn was confused when he heard that Charlie Munger, a famed investor, disparaged splitting investments into smaller chunks. Munger supposedly said this practice should be called “diworsification.” He argued that if you have a good, focused portfolio, why weaken it with additional lesser opportunities? But Shimshi had also read many investment articles that said that diversification was necessary. And, of course, he knew that the Gemara encouraged diversification. What was he missing here? 

Is there a balance to be struck between smart diversification and silly diworsification?

It Depends

Every successful investor has had investments go bad on them, and they usually manage their risks via at least some diversification. If you pay attention to the nuance in Munger’s diworsification warnings, he notes that diversification is as basic as 2 + 2 = 4. Limited knowledge of how the future will unfold creates risk, necessitating some hedging via diversification. But, like every other tool or strategy, diversification must be pursued with wisdom and intent. A dogmatic and simplistic diversification approach often leads to a poor portfolio. That’s the diworsification Munger speaks of.

Schlemazel Investing

Say Shimshi is invested in a few well-known mutual funds but is unsure about their quality and potential. Then the town schlemazel offers to take some of Shimshi’s money and “invest” it for him in a very special way. Obviously, this is an example of diworsification. Shimshi should be learning more about investing if he wants to improve his portfolio, not pouring it down the drain with the schlemazel’s kind assistance. This should be obvious, but you’d be surprised.

Junk Diversification

Take bond diversification. Many investors own some “high-yield” junk bonds in an attempt to diversify. But these bonds usually don’t offer the upside that stocks do despite containing similar risks. Occasionally, junk bonds trade at a price that makes them worthwhile, but most people add them to the pot without thought for “diversification” purposes. Adding additional “ junk “ slivers” to your investment account doesn’t make it a better, safer portfolio.

Simple is Strong

As a professional investor, Munger prefers meticulously selecting a few great stocks and monitoring them carefully versus owning a limp portfolio of 100 poorly researched options. Those who can’t do intense investment research have little choice but to increase their diversification to lower their risks since settling on just a handful of stocks doesn’t make sense for them. In that case, Munger recommends investing in a few low-cost index funds which are easily selected and monitored versus “diworsifying” into an extensive, haphazard mess of investments that aren’t.

The Biased-Broker Angle

Munger lays much of the blame for diworsification on biased brokers and advisers. Complexity favors the investment industry, allowing it to sell inferior products to those who can’t pierce the piles of jargon and making financial advisers indispensable to overwhelmed clients. A simple, streamlined portfolio does not generate nearly as many commissions as one chasing the next hot thing. Also, it’s harder to justify an ongoing fee to the financial adviser who parks money in a few simple index funds. Knowledgeable financial advisers can add value in various ways, but clients need to be aware of their bias for diworsification.

More was Less

Munger’s definitely got a point. A large portfolio I reviewed once was diversified into dozens of mutual funds, but with little rhyme or reason. The common theme of these funds was that they were managed by the company the recommending broker worked for. You can build a great portfolio using just a handful of quality funds, and loading up on a vast array of random funds was good for this broker, not the portfolio. She was diworsified, not diversified.

Naïve Diversification

Beyond conflicts of interest, psychological biases drive what researchers call “naive diversification.” When humans have to make complex decisions and are given multiple options, there’s a tendency to diversify, grabbing a bit of each option out of fear of making the wrong choice. Sometimes, like with a food buffet, this works out—we sample a bit of each item on the menu to ensure we don’t miss out on something sensational. But other times, like in investing, it can cause issues—choosing a bit of all the many options often makes a portfolio worse, not better.

1/N in 401(k) Plans

Naive diversification shows up strongly in 401(k) retirement plans and has been documented as the 1/N approach. Employees who know little about investing and are given a menu of mutual funds to choose from tend to divide their 401(k) contributions evenly across all of the funds offered to them (i.e., 1/N, with N being the number of funds made available to them). In other words, if the 401(k) retirement plan offers 10 funds, the 1/N investor puts 10% of their money into each; if there are 20 funds available, they will divide their investment into 20 equal parts.

Naïve Diworsification

This simplistic investment approach often leaves investors with a portfolio that seems diversified but is out of whack with their needs. Each individual participating in a plan has different goals and risk tolerance, and these factors should determine their asset allocation, not the number of options on the menu. Instead of cutting through the confusion, learning about the options, and then building a strong portfolio, people choose a diverse portfolio. Having a randomly diverse plate of food is fun and interesting, but a randomly diverse portfolio usually produces inferior and sometimes disastrous results.

Seichel Required

Within 401(k) plans, the financial industry has actually provided a great solution to combat naive diversification, called target-date funds. These simple, all-in-one portfolio options select investments and manage risk based on the investor’s age. Often these are excellent options, offering proper diversification and automated investment management for very low fees. Ironically, some 401(k) investors naively diversify into all the target-date funds made available to them instead of choosing the one that corresponds with their age group!

No matter the investment type, the buck ultimately stops with the investor. Some seichel and effort are always required, simply diworsifying won’t cut it.

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