Diversification or diworsification?

By DAVID MOON, Moon Capital Management
February 27, 2005

In graduate school, every finance student is required to take the Diversification Class. This class is sacrosanct among all school curricula, particularly in graduate school. Graduate school is where all aspiring young investment advisors learn the special answer to all investment quandaries: 'diversify.'

When all else fails, diversify. If you're not sure what to do, diversify. If you're just getting started, diversify. If you're nearing retirement, diversify. If you're conservative, diversify. Aggressive? Diversify. If you hate your mother, want to lose weight or drink too much, diversify, diversify, diversify.

If you study the syllabus for the Diversification Class, you will find a number of subsections on asset allocation. Asset allocation tells you not only to diversify but to diversify across specific asset classes. Big stocks, little stocks, medium-size stocks. Growth stocks, value stocks, hard-to-classify stocks. Domestic stocks, foreign stocks, multinational stocks. Livestock, Woodstock.

What about bonds? There are the taxable and nontaxable varieties. All sorts of different credit ratings. Different maturities. Bonds, brunettes, redheads; something for almost anyone.

We haven't addressed inflation hedges yet. The Diversification Class says we should also own real assets. Real estate, both commercial and residential. Undeveloped land. Storage buildings, cattle farms and vacation property.

A properly diversified portfolio must also include investments in hard assets like gold, silver and weapons-grade plutonium.

Finally, to protect against volatility caused by the absence of an asset class that you may have inadvertently overlooked, an investor must also include all sorts of esoteric derivative investments in his portfolio ' things like calls, puts, forward contracts and reverse lay-ups.

Following the precepts of the Diversification Class, a wise investor with a $100,000 portfolio will wind up owning thousands of individual stocks and probably hundreds of bonds. He will own a number of different international stock funds, most of which will hopefully cancel each other out as far as currency fluctuations are concerned. The real estate holdings will be spread among a single REIT if he's lucky; if he's unlucky, he'll own some horrible limited partnership a guy at church sold him. He'll be paying rent on his safe-deposit box to hold the two gold coins he forgot about. But he will be diversified.

When they don't know what to do, some people do nothing. Others do everything''a little of that, a little of this, and this, and this. One perennially successful investment manager, Marty Whitman, calls 'over-diversification a proxy for knowledge ' and a poor proxy at that.' When you diversify a portfolio to the point that you own everything, you've guaranteed mediocrity.

In college, if my friends and I couldn't agree on a specific cuisine for dinner, we would visit Duff's, the first all-you-can-eat restaurant I'd ever seen. If you couldn't decide what to eat, at Duff's you could eat anything ' or everything. But it all tasted the same. The macaroni and cheese tasted just like the green beans and the corn. There was no difference in the taste of the fish, chicken, fried steak, French fries or onion rings. Everything was bland, but there was plenty of it. Nothing was good, but nothing was different. Everything needed salt and Tabasco.

I am often reminded of Duff's when I see portfolios constructed according to the teachings of the Diversification Class.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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