The Dirty Secret of Diversification

The Dirty Secret of Diversification You probably heard mixed things about diversification; most of it good but not all of it. Amongst the detractors you can find content on the internet where Mark Cuban or Warren Buffett impune diversification. Please forgive their ignorance. Qualified to the constraints of trading costs and research capacity there really is no downside to additional diversification. So what then is diversification’s dirty secret? The dirty secret of diversification is simply this: all of the diversification benefit you could ever achieve is obtained by only the first two assets, providing that those assets are equally weighted. Continuing to add assets in attempts to increase the diversification above and beyond this will in fact add diversification but the benefit of diversification cannot be improved upon. Effectively, the first two assets of a equally-weighted, uncorrelated portfolio provide all of the risk reduction and diversification Alpha. All additional assets are only adding redundancy. Is this redundancy bad? not at all. In fact this redundancy is exactly half of what diversification is. Redundancy is what protects you from stock-specific, also known as, idiosyncratic risk. This is the risk that you have an asset in your portfolio that implodes, unrelated to the general economic conditions. Nassim Taleb, author of “The Black Swan” would call redundancy Antifragile. The challenge then in portfolio Construction is to keep sourcing additional assets that offer non-correlation – to maintain the diversity of the systematic risk, while continuing to add redundancy. This is the true art of portfolio design. Adding redundancy is good. But adding portfolio diversification through redundancy while NOT diluting your systematic risk diversification is key. This should be one of your top reasons to disqualify your next (otherwise) good investment idea.