Thursday, October 05, 2006

evaluating the benefits of diversification

Traine Investor at A Private Portfolio is a very couragious blogger. He never shirks from addressing contravertial topics and often takes a creative and unusual perspective.

In a recent post discussing diversification, Trainee argues both sides of the issue. Ultimately he concludes that diversification is best for him.

I, on the other hand, found that although I joined his conclusion, I have far more particular oppinions on the matter.

I seriously enjoyed Trainee's earlier posting on the wastefulness of emergency funds - what a wonderful perspective! And quite honestly probably financially correct.

Now as to Diversification being mostly good. It raises an interesting point, that focussed investments often exceed the returns of diversified investments, however, I actually question the long term ability of the focussed / concentrated investor to consistently time the market and pick winning players.

Over long periods of time, virtually no major fund manager has managed to beat the market (substitute for diversified portfolio). We can all point to the Oracle of Omaha, but I'd like to use Warren Buffet as a counter example. If there were so many long term players able to beat the market, we would all use different examples.

Concentrated investments may make sense for someone looking to take a quick gamble on the market - but that's all it is - gambling. If you calculate the average returns for gambling over 20 years - maybe other games would be more profitable.

Trainee also raised an interesting point regarding diversification of investments. Re. the point that diversified portfolios cost more to maintain than concentrated portfolios - I think the example actually prooves something different:
  1. low cost index portfolios achieve diversification much more cheaply than hand built portfolios (attempting to create diversification).
  2. low cost index portfolios are cheaper than small concentrated stock portfolios as they
  • do not have to pay money and time for research.
  • do not have bid/ask spread fees associated with them (exccept for ETFs)
  • do not require significant management activity except at times of rebalancing.

Do you know of an example where concentration of risk has actually performed better than the market over a long period of time (20 years)?

Have a wonderful day,


1 comment:

traineeinvestor said...

Thanks for the comments re my blog. I haven't called myself the traineeinvestor for nothing - I am still learning by making mistakes :-) so commentary is always appreciated especially where, like yours, it expands my thinking on an issue.

I agree with the comments you make regarding low cost index funds - something I didn't include in my post. Also, pointing to individual examples of those very few managers who do managed to consistently beat an index does serve to show how rare such manangers are.

Perhaps where I got to at the end of the thinking process on this issue is that risk concentration gives you a better chance of beating the index than wide diversification. It also increases the chances of doing worse than the index. Very few people seem to consistently end up doing better over long periods of time.