Forum Archive Index - February 2003

["Capitalist" <capitalist@paradise.net.nz>]

A forward from another group regarding the epistemological aspect of
investing.... Snoopy, Travis, Phaedrus...I know you're out there....

>>Thinking out loud on the subject of diversification:

There's another flaw with the diversification theory, beyond not accounting
the value of your time (as Steve pointed out) and related to the asymmetric
information problem (as noted by Kirez): the assumption that
correlative/non-correlative relationships are invariant and/or linear over
time.

The only way that the diversification of a portfolio can reduce risk (by
smoothing out deviations from expected value) is when the relationships
between the price movements of each of the investments contained within the
diversified portfolio are truly random (non-correlative, either positively
or negatively) or corellating in a known, invariant pattern.  If the market
behavior of the various elements of the diversified portfolio starts to
correlate in any significant way, or the corellations start to fluctuate
significantly, I would argue that risk exposure is actually magnified
disproportionately over a non-diversified investment strategy.

Since true randomness is a theoretical ideal, and not a true reality
(especially when we are talking about the highly complex
inter-relationships
which spring from economic activity), diversification can only support a
portfolio during those times when the markets' behavior most closely
approximates the ideal of randomness or corellative invariance.  The
problem
is, the markets' behavior doesn't always do that.  It is nearly impossible
to know when the correlative relationships are all going to change out of
their established patterns, which they do with some regularity.

A lot of diversified portfolios got hammered over the last few years simply
because the relationships between investment sectors were not actually
random, and started showing some new heavy positive correlation (to the
downside).  If the majority of market sectors are down, diversification
isn't going to help you at all (and might actually hurt you).

Frankly, diversification theory appears to me to be a rationalization
contrived to provide psychological support for investor complacence, and I
think this is related to the point Kirez was trying to make about Buffet,
the value of researching your investments in depth, and building value.
Diversification theory says, essentially, that if we go by a few general
assumptions about the markets, we can invest our money without having to do
a lot of research into the particulars of each investment.  In order to
offset the increased risk inherent to putting your money in investments you
don't really know in depth, we are supposed to spread the money around so
that any bad bet won't ruin the whole portfolio.  The problem then arises
as
to what happens when entire market sectors, or even sectors of sectors,
start moving together against you.  That's when you discover that
diversified market theory merely transfers your gamble from a select few
investments onto broader economic forces (which are far less easy to
analyse
and understand, and which you really haven't tried to understand beyond a
statistical approximation in formulating your diversified investment plan).

This then brings up an epistemological problem that relates directly to the
nature of statistical reasoning itself (since diversified portfolio theory
relies so heavily on statistical reasoning).  Statistical reasoning is an
epistemic method for evaluating the relative truth of competing claims in
the absense of definitive particular information in support or
contradiction
of any one of them.  In investing, the information is largely available (as
Warren Buffet would tell you) to allow you to form a judgment without
relying on statistics for approximations (you can get all the financial
statements for Company A and Company B, along with supporting information,
to evaluate their relative strength as investment prospects).  Using
diversification as a primary investment method is effectively the choice to
*ignore* available specific information in favor of approximations (e.g.
assuming that the particular information is NOT available, even when it
usually is).
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