Thinking about diversification in an uncertain world

 

"The "know-nothing" investor should practice diversification, but it is crazy if you are an expert. The goal of investment is to find situations where it is safe not to diversify." - Charlie Munger

What is the best strategy if you are uncertain and not sure what will happen with the US election and the global economy? Diversification. What is the worse strategy if you have a view on the election outcome or the global economy? Diversification. 

There can be too much diversification, and the level of diversification should be viewed as dynamic. Diversification should be assessed on a regular basis based on the investor's knowledge and market environment. Similarly, the type of diversification employed should be regularly assessed. For example, holding a cap-weighted benchmark may not provide the diversification desired. 

See:

Diversification - You need "intelligent supervision"

A simple taxonomy of diversification - All diversifiers are not alike

A primary goal of effective investing and portfolio management is to find the investment where you may have an edge. This is not a perceived edge but a real edge or view that you are willing to commit capital for as a risk. This does not mean there is certainty with your bets. Your edge is a subjective expectation for gain relative to risk. 

The problem with using any subjective expectation is that you don't have good feedback on the quality of your thinking except through measuring the results in your portfolio. A novice, by definition, should take smaller bets and have greater diversification because the measure of your subjective success is limited. As the quality of your subjective expectations increases, the degree of diversification should decrease. If there is no measurable skill, high diversification should be maintained. 

Diversification is a management tool that should change with your skill at assessing the current environment. You can be a skillful investor, but perhaps not under current conditions. Hence, today may call for more diversification.