Warren Buffett, the world's most successful and famous investor, once noted that diversification
was for people who don't know what they're doing. Diversification means spreading your investment portfolio over a wide range
of different assets in the hope of reducing risk. Buffett prefers to pick his winners and back them confidently.
I don't see Buffett's quip as
a criticism of diversification. The thing is, when it comes to picking undervalued shares, bonds or commodities, I'm no Buffett. Relative to the highly informed traders at the heart of the market, I am ignorant. So it's diversification for me. Quite simply, I don't put all my eggs in one basket. That seems obvious enough, but in fact two Nobel memorial prizes have been awarded to economists for work on that particular theme. James Tobin, winner in 1981, was explicitly reported as having won the prize "for his work on the principle of not putting all
your eggs in one basket".
Harry Markowitz, another Nobel laureate economist, developed the approach, explaining how by seeking
out negatively-correlated investments, such as an ice-cream company and a raincoat manufacturer, investors could minimise risk. But when Markowitz took a job in the early 1950s and had to decide how to invest his pension, he ignored his newly minted theory and simply
put half his contributions into
bonds and half into stocks.
His apparent lapse has often been seen as a point in favour of behavioural economics, which uses psychological
tools to demonstrate how we behave irrationally, in defiance of standard economic theories. But the interesting thing about what Markowitz did is that, while it did indeed defy his theory, it's not at all clear that it was irrational.
Here's why: to make his theory work perfectly, we need to make some simplifying assumptions. In particular,
we need to assume that we actually know the distribution of risks and possible returns for any asset in which we might invest. But we don't: we need to estimate them based on historical returns.
In 2009, three economists, Victor DeMiguel, Lorenzo Garlappi and Raman Uppal, compared a number of souped-up versions of the Markowitz theory with the homespun strategy he actually followed: in the lingo, it's called "1/N" and it involves distributing your cash equally amongst
all alternative investments.
DeMiguel and co showed that the naïve 1/N approach simply works better than
the clever algorithms until
a colossal amount of data
is available. So perhaps Markowitz was wrong in theory and right in practice. And perhaps "don't put all your eggs in one basket" is all the advice we really need.
Tim Harford is a Financial Times columnist
and author of Adapt: Why Success Always
Starts With Failure (Abacus, £8.99).
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