Diversification

I am not a big fan of diversification. I believe that the decision to diversify is more a matter of personal preference than sound economic decision making.

A degree of diversification makes sense. There is the possibility of fraud. There is the possibility of an unfortunate surprise. We need to prepare against such contingencies.

But the greater argument in favor of diversification does not withstand scrutiny. It assumes that you cannot discern which investments are more likely to prosper. Readers of David Dreman, Lowell Miller and James O’Shaughnessy know better. In addition, segments of the stock market are tightly related to the price of the overall market. Large and Small Capitalization, Growth and Value: all react similarly to valuation as measured by P/E10. Refer to my early articles on Gummy Slices.

Those with a short term outlook may need to diversify to protect themselves from themselves. Those with a longer time frame will pay attention to what often develops slowly, but consistently.

I remember when owning one mutual fund was considered diversification. Nowadays, people own a variety of mutual funds in the name of diversification. They would do better if they were to buy one or two broad based index funds. They could, at least, save on expenses.

If you like owning lots of companies, fine. By all means, do so. You have my blessings. Just don’t tell me that you are diversifying risk. Risk is tied tightly to valuations.

Have fun.

John Walter Russell
May 5, 2008

Read Rob Bennett's reaction in "Obtaining ‘Permission’ to Ignore Valuations."

April 11, 2008 Letters to the Editor