Why should we diversify?
Photo: Petr Kratochvil. Source: Public Domain Pictures
The reason to diversify is simple in some ways. Don't put all your eggs in one basket, because that basket may fall. Spread things out - you don't know what disaster lies ahead.
And the math of diversification is pretty straightforward: your average risk is the average of all your asset returns, but volatility goes down based on how uncorrelated those assets are. If one stock zigs when the other zags, the overall portfolio is a lot more stable. By combining a lot of assets with different characteristics, you get an efficient portfolio.
Efficient Frontier: Source: Wikipedia
But the psychology of diversification is hard. By holding assets in different asset classes from different industries that sit at different places in the capital structure, you can pretty much guarantee that some of your investments will look lousy.
Consider the mid-2000s. Emerging markets were hot, generating 30% returns several years in a row. Growth stocks were dogs. Now, things are reversed. Emerging markets are beset by falling commodity prices and weakening global demand, while growth stocks shine.
Periodic Table of Investment Returns. Source: Callen Associates
The temptation is to get rid of the assets that aren't doing so well - like cutting the slow kids from a sports team. But that's the mistake. Asset prices are adaptive - they adjust to our expectations. By avoiding assets with low expected returns, you make it a lot harder to beat the market's expectations.
The surest way to underperform is to sell assets when they're down. No one knows what the next hot sector will be. Asset returns are like the wind: they blow in one direction, then change. We just don't know when that change will happen. And whether the next breeze will be a light zephyr - or a hurricane!