Monday, August 16, 2021

Diversification as ignorance protection

"Diversification is a protection against ignorance. [It] makes very little sense for those who know what they're doing." - Warren Buffett

Who isn't for diversification? Who admits their ignorance? These two topics go hand in hand. If you have strong knowledge about an investment, the bet size should be consistent with that knowledge. Better knowledge, less risk, greater exposure, and less diversification.  It is that simple, yet while we may have an information advantage, we can still be wrong. Diversification still protects against the chance of being wrong.  

As important as our perceived knowledge is a second question on the common knowledge held by others. Our knowledge needs to be unique, yet we don't know the knowledge that others have. It is not our absolute knowledge that matters, but our relative knowledge versus the market. It is not clear what information is embedded in prices.

Unfortunately, we also don't know the reaction or behavior by other investors to new information will be. We can only guess what their actions will be. We can have perfect knowledge about future events, but we cannot guarantee the market reaction to any piece of news. We may precisely know the employment numbers, but that does not mean we will be guaranteed excess returns because we cannot predict the action of others. 

Diversification protects against ignorance, not just our lack of knowledge about an event or company but also the knowledge and behavior of other market participants. The knowledge problem is just too complex. Regardless of how much knowledge you may have, everyone needs protection against ignorance. 

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