Colorful Swans

John Hempton over at Bronte Capital makes an interesting point about diversification.  I’d not fully appreciated this.  The textbook story about diversification is that can smooth out your risks (good and bad) by loading up on investments that are uncorrelated with each other.

If you take the lesson of diversification to heart it leads to a lack of  loyalty.  It encourages alienation even from your own skills.  John points out there are a few citizens of Iceland who are very happy because had 20% of their wealth invested overseas.  All the more loyal citizens aren’t so happy.    You certainly should never let a significant portion of your wealth be invested in your employer, since if they collapse would would lose both your job and your wealth.  In fact you should probably not be invested in the industry your professionally expert on.

Since most well educated people know about diversification you can make jokes that play off how it encourages disloyalty and alienation.  e.g. “Nice kids!”, “Thanks.  It’s not so hard.  You just have a few dozen and throw away the discard ones.”  What I additionally love about that joke is how it presumes that your kids are competitive rather than complementary (illustrated here, (note the there == happy).  There is something quite meta about the recent crisis of faith among those who placed their faith in diversification.

The search for ways to diversify leads to investment mavins to collects lots of data so their statisticians can discover what is and what isn’t correlated.  Which is, of course, only as good as your data and your statistical model.

What John points out is that much of the risk (good and bad) in a portfolio comes from the black swans.  Which is an entirely different way of looking the problem of how to diversify.  You should not be so interested in the steady bits.  It’s all about the surprises.  Apple, Iceland, Microsoft, biology, politics and your relatives are full of surprises – different kinds of surprises.  A well diversified portfolio should be surprising and fundamentally disconcerting.  First you need to admit that your portfolio is all about the swans, and then you want to assure they are not color coordinated.  You may not know what your “unknown unknowns” are, but at least you want them to be different.

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