Diversification is often hailed as a great safety feature of modern investment theory. It almost seems like the belief in diversification as the great portfolio has taken taken on the quality, or rather lack thereof, of blind faith.

Keep in mind that diversification really requires uncorrelated assets. If a large fraction of people buy the same kind of previously uncorrelated assets in the same kind of way, those assets are no longer uncorrelated. They now trade together according to the behavior of the group that bought them as a group of initially uncorrelated assets.

Effectively offering up a basket as being uncorrelated is selfdefeating because people buying the basket consequently tie those assets together.

This is also why it is very hard to “escape” into alternative assets like global stocks or commodities these days. The widespread adoption of modern asset allocation theory has essentially made this impossible. In particular, not everybody can be safe using asset allocation. Ultimately, someone has to hold the hot potato.

Consequentially, since asset allocation is widespread and widely believed to be safe, it is likely one of the most dangerous theories that exist.

In that regard, I am somewhat pleased that well diversified and properly allocated portfolios to a really heavy dive in 2008/09. At least I can point to one instance of this hypothesis being true. There is no one investment method which is inherently safe.

What did not take such a heavy dive was a portfolio comprised of single stocks. The reason is that it was not as heavily tied to the failing sectors of the economy like wide index/asset allocation models were.

The conclusion is quite obvious. If you want to derive a profit, you must think and do something different from the majority. (In general, what you do should correspond to reality but not necessarily albeit possibly in the long run due to ergodicity). And if you want safety, you can not rely on the autopilot. Someone with a brain will figure out a way to profit from it. One sign of this is the increased volatility of the major indexes. Every time they whip up and down, someone is making money from those who are adding or removing positions in an uninformed manner.

As they say around poker tables. If you don’t know who the sucker is, it is probably you. Indeed, who are you currently getting your investment advice from? Yourself? Wall Street? Main Street?

Originally posted 2010-05-05 01:48:09.