I want to call to attention a type of diversification that I think is especially relevant now and typically one that evades measurement.
I’ve come across this type of diversification a number of times and I’m just taking to give it a name and some better definition.
In essence narrative diversification is when the investments in your portfolio are not based on the same story, or macroeconomic hypothesis.
Narrative diversification becomes especially important as systemic risk increases and the world tends to drift towards a more risk-on risk off mode.
Now, Coronavirus headlines are dominating the news cycle and investment psyche. It is easy for investors to form some basic hypothesis about the investment climate as it pertains to the coronavirus. Then, investors can come up with a number of investment ideas.
However, if my list of investment ideas involves buying airlines and restaurants and casinos, health insurance companies, medical diagnostic companies and home fitness equipment providers; do I really have good diversification?
My trade thesis is that we will be emerging from the corona virus and returning to mostly normal over the course of the next few months.
I could probably build a very well-diversified and quantitatively-validated diversified portfolio. At least based on historical data. But going forward, there is a problem: All of my investments are based on the same narrative.
If all of my investment ideas are based on this common factor I have violated the principle of narrative diversification.
This type of diversification is difficult to quantify, because the narrative is typically forward looking and therefore not exactly matched to any historical data. This quantification challenge leads narrative diversification to be insidious. In fact this can be trickier than other diversification destroying homogenizing factors, like hedging strategies or dynamic leverage.
Fortunately, the solution for narrative diversification is quite simple.
Having awareness that narrative diversification exists and whether the investments you own or plan to own are of the same narrative.
Follow the rule of three. Have at least three totally-different narratives used to select your investment ideas. Try not to have much more than a third of your portfolio belonging to the same narrative.
This simple awareness and rudimentary action on narrative diversification can save your bacon.
Insights from the field of psychology suggest that the majority of ideas humans have are actually wrong. Your narrative is your creation and it is natural to get attached to them. Behavioral economists would have you on guarde against “Expectation Bias” – basically the process of objectively gathering only the evidence in support of your expectation (position / narrative).Your narrative may be very logical and well thought out, but there are many risks to your narrative becoming reality. In addition to the obvious alternative to your narrative there are an infinite array of future possibilities that we haven’t considered or imagined. Your narrative is just one future among a vast expanse of probabilities. Don’t fall in love with your ideas. Diversify them!
By following good principles of diversification and investment prudence, you can protect against losses and participate in investments not subject to your presumed worldview.