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.
James’ professional orientation points at the zenith (and sometimes nadir) where technology and investments intersect. He is a Fintech entrepreneur and has served twenty years of a lifetime sentence.
James is a patented inventor, quant pioneer and investment manager. He is the founder of Gravity Investments, a unique investment and technology services firm centered on James’ inventions for diversification measurement, optimization, visualization, and analysis. In the development of the platform, James has pioneered A.I applications, diversification attribution, down-side diversification, portfolio re-optimization, full-lifecycle strategy optimization, programmable investment policy statements and core-satellite optimization techniques.
In working with advisors, funds and money managers as both a strategic sub-advisor and software consultant, James has consulted and trained hundreds of professional investors on portfolio design and optimization. James has a unique ability to look at any investment process and find practical, intelligent and often quantifiable opportunities to improve the investment product.
Inspired by the work of Nobel Laureate Harry Markowitz and the efficient frontier, James has championed and pioneered the science of diversification. James’ technology has advised
or assisted in over 30 Billion dollars of investor capital. His vision of a more perfect investment management system is at the heart of Gsphere ( www.gsphere.net )
His passion for performance, curiosity for the unknown, and drive to excel empower his service to investors.
James is Founder and CEO of Portfolio ThinkTank (the B2C company) www.portfoliothinktank.com, Founder & Chief of Financial Engineering at Gravity Investments www.gravityinvestments.com (the B2B company) and Chief Investment Officer at Gravity Capital Partners, a wholly owned SEC Registered Investment Advisor.