Kyle Mowery of GrizzlyRock Capital recently wrote a white paper titled "Diworseification – How Investors Can Avoid the Scourge of Overdiversification with Best Idea Funds." His paper has sparked a debate regarding the potential underperformance risks due to over diversification. n
According to the report, an over-reliance on diversification to reduce portfolio volatility succeeds at limiting an active manager's business risk, often at the expense of the client's return.
"Advocates of extreme diversification – which I think of as overdiversification – live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great," Seth Klarman, of the Baupost Group, said in the report.
The GrizzlyRock Capital study found that U.S. stocks returned roughly 16 percent in 2012. However, despite these potential rewards, hedge funds run by active managers returned just 6.16 percent to clients.
Bill Ackman of Pershing Square was quoted in the report saying "As a result of overdiversification, their (active managers) returns get watered down. Diversification covers up ignorance. Active managers haven't done enough research into any of their companies. If managers have 200 positions, do you think they know what's going on at any one of those companies at this moment?"
The challenge is, as a particular investment performs and becomes a larger percentage of your portfolio while underperformers languish, diversification maintenance through rebalancing results in you selling a portion of your winners and rolling the proceeds into your losers. Intuitively, this does not make much sense. Alternatively, investors can use risk management alerts such as those provided by SmartStops.net in an effort to let their winners run while having risk alerts in place enabling them to exit early in a down trend. When equity is freed up from a sale, it may be a good time to maintain diversification by investigating new alternative opportunities as opposed to simply adding to an existing underperforming position.
While diversification is an important tool in risk management, it needs to be deployed intelligently and should be deployed in conjunction with other risk management strategies.
At SmartStops, our analytics engine can empower individual investors to adopt adaptive exit strategies so they can pursue increased rewards by effectively managing risk on their own. To see how using the risk management methodology powering SmartStops is better than other methods, click here. With our analytic engine and tools like our Position Sizing Calculator, we empower investors to take control of their risk without limiting their potential rewards.