Why retail investors shouldn’t overdiversify | opinion
email rounding up the latestNobel-prize winning economist Harry Markowitz wrote that “diversification is the only free lunch in finance”. A free lunch sounds good, but the reality is often bland sandwiches, a plate of crisps and lukewarm coffee. Private investors do not need to diversify as much as they think.is conventional wisdom. The idea makes a lot of sense: by diversifying across a broad range of assets an investor can reduce both risk and volatility.
This is because not all stocks are created equal. Indeed, some stock ideas are better than others. But if you were to follow conventional wisdom and buy 20 stocks equally then your best idea would be worth five per cent of your portfolio — the same percentage as your worst idea. Diversification, then, is a protection against risk. Specifically, it’s a protection against things you don’t know and can’t control.
UK small-caps often present asymmetric risk/reward opportunities because this part of the market is unloved. It’s this opportunity that private investors should be attempting to capture, and not diversifying because they’re led to believe they need wide exposure. Focusing on the best ideas yields better results. As private investors, we also have several advantages over our professional counterparts.
At best, diversification protects against sharp downwards volatility from one stock. At worst, it robs private investors of the chance for spectacular gainsPrivate investors can also diversify by buying stocks that are relatively uncorrelated to the market as a whole. FTSE 100 stocks and large caps find themselves beholden to macroeconomic conditions, whereas small-cap stocks can deftly navigate storms.
My belief is that investing in 10 well-researched and uncorrelated stocks is well diversified and allows a chance for growth.
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