Minor Axiom II – The Indissoluble

Resist the allure of diversification

Throughout the length and breath of the investment world, they call it diversification. They could just as easily call it diversity.

That’s an indication of how overblown it is.

After all these decades of usage it’s too late to change the word now, so I will go on using it in the commonly accepted way. Diversification. Let’s see what this ponderous and inelegant word means and how it might affect you in your efforts to grow rich.

As used in the investment community, it means spreading your money around. Spreading it thin. Putting it into a lot of little speculations instead of a few big ones.

The idea is safety. If six of your investments get nowhere, maybe six others will get somewhere. If Hey Wow Electronics goes bankrupt and the value of your stock drops to three cents, maybe your Hoo Boy Computer speculation will turn out better. If everything collapses, maybe your bonds, at least, will increase in value and keep you afloat.

That is the rationale. In the litany of conventional investment advice, having a ‘diversified portfolio’ is among the most revered of all financial goals. Only one thing tops it: having a diversified portfolio of investment-grade securities. If you’ve got that, you’ve got the world by the tail!

Or so they like to tell you. The fact is that diversification, while reducing your risks, reduces by the same degree any hope you may have of getting rich.

Most of us middle-class plungers, at the start of our speculative adventures, have only a limited amount of capital to play with. Let’s say you have $5,ooo. You want to make it grow. What are going to do with it? The conventional wisdom would say diversify. Make ten bets of $500 each. Buy $500 worth of GM because the auto industry looks lively, put $500 into a savings account in case interest rates go up, $500 into gold in case the bottom drops out of everything, and so on. There – you’re covered for all kinds of eventualities. Makes you feel safe, doesn’t it? Safe from just about everything – including the danger of getting wealthy.

Diversification has three major flaws:

1. It forces you to violate the precept of Minor Axiom I – that you should always play for meaningful stakes.

If your entire starting capital is itself not very meaningful, diversifying is only going to make things worse. The more you diversify, the smaller your speculations get. Carry it to extremes and you can end with amounts that are really quite trivial.

As we observed under Minor Axion I, a hefty gain on a small amount leaves you just about where you started: still poor. Let’s say your $500 speculation on Hoo Boy Computer works brightly, and the stock price doubles. What’s your gain? Five hundred bucks. You are never going to get into the upper tax brackets that way.

2. By diversifying, you create a situation in which gains and losses are likely to cancel each other out.

Leaving you exactly where you began – at Point Zero.

You bought two stocks which were, we’ll say, of somewhat less than investment grade: Hoo Boy Computer and Hey Wow Electronics. If the two companies were to be blessed with boom conditions, you figured, the trading prices of their stocks would rise. All right, let’s say your hunch was correct. The companies have prospered, and you’ve gained $200 on each of those $500 speculations.

But at the time you were buying Hoo Boy and Hey Wow, your investment adviser solemnly warned you to hedge your bets by diversifying. In case of bad times, he said, you ought to get into some fixed-interest stock and gold.

So you bought $500 and worth of gold and $500 worth of fixed-interest stock. And now here you are in the middle of a boom. Interest rates are soaring because of business and consumer loan demand, so the value of your fixed-interest stock is sagging. It’s gone down $100. As for gold, everybody who owns the yellow metal is frantically selling it to raise cash. They all want to get into the thundering Wall Street bull market or put their money into those tempting new bank accounts with the eye-bugging interest rates. The value is leaking out of your gold like water out of an old rusty bucket. It’s down $300.

So you have gained $400 on Hoo Boy and Hey Wow but lost $400 on your fixed-interest stock and gold. The whole exercise has been a waste of time and effort. What’s the use?

3. By diversifying, you become a juggler trying to keep too many balls in the air all at once.

If you have just a few speculations going and one or two turn sour, you can take defensive action. The Third Axiom and others will address this situation. But if you have a dozen balls in the air and half of them start to go in the wrong direction, your chances of getting out of the dilemma without a black eye are not very good.

The more speculations you get into, the more time and study they will require. You can become hopelessly confused. When things go wrong – which is inevitable, as you are surely aware – you can be driven to near-panic as one problem after another presents itself. What often happens to people in this kind of pickle, especially novice speculators, is that they become paralyzed. They fail to take any action at all because they are being pressured to make too many painful decisions too fast. They can only stand and gape, stunned, as their wealth dwindles away.

When you think about these three major flaws of diversification and weigh them against its single advantage, safety, it beings not to look so good.

A little diversity probably won’t do any harm. Three good speculations, maybe four, maybe even six if you are strongly attracted to that many all at once. My personal rule of thumb is to have no more than four going at any one time, and most often I keep the number to three or less – sometimes just one. I’m uncomfortable with more. This is largely a matter of personal preference and individual thinking habits. If you feel you can effectively handle a higher number, go for it.

But don’t diversify just for the sake of diversity. You then become like a contestant in a supermarket shopping contest, in which the object is to fill your basket fast. You go home with a lot of expensive junk you don’t really want. In speculation, you should put money into ventures that genuinely attract you, and only those. Never buy something simply because you think you need it to round out a ‘diversified portfolio’.

As some say around Wall Street, “Put all your eggs in one basket, and then watch the basket”. This is one old financial bromide that stands scrutiny. Whoever fist said it was obviously not a diversification fan. It is much easier to watch one or a few baskets than a dozen. When the fox comes around to steal your eggs, you can handle him without whirling around in circles.

Speculative Strategy

Now let’s review the First Axiom quickly. Specifically, what does the axiom advise you to do with your money?

It says put your money at risk. Don’t be afraid of getting hurt a little. The degree of risk you will usually be dealing with is not hair-raisingly high. By being willing to face it, you give yourself the only realistic chance you have of rising above the great unrich.

The price you pay for this glorious chance is a state of worry. But this worry, the First Axiom insists, is not the sickness modern psychology believes it to be. It is the hot and tart sauce of life. Once you get used to it, you enjoy it.