You probably came across the idea of diversification fairly early in your passive investing adventures.
Diversification is an age-old concept, after all.
According to The Bible
“Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.”
And in the 1600s the first East India companies enabled speculators backing British, Dutch and French adventurists to split their exposure across several of these prototypical limited liability companies – lessening the chances that all your worldly wealth would end up in the hold of a Barbary corsair.
Nowadays it’s easy to achieve wide diversification. Index tracking funds enable you to invest your money across markets and into different asset classes.
A simple portfolio can be created with just a handful of funds, with your precise allocations tweaked to suit your temperament and attitude to risk.
The only pirates you need to worry about are rapacious fund managers!
The theory of investing in everything
It took academia a while to pin down exactly how diversification works, but the now-famed Harry Markowitz got the game going by deconstructing how risk and reward is distributed across portfolios.
The rest is history, or rather Modern Portfolio Theory, as Sensible Investing explains in this video:
Says Art Barlow from Dimensional Fund Advisors:
“Really the cornerstone of all of what we call Modern Portfolio Theory rests on this idea of diversification. Until Harry Markwowitz gave what was almost an engineering analysis of how stock price movements interacted with each other, nobody had ever really considered it.
Even though prices don’t move in nice, let’s say, sine-wave fashion, prices do go up and down over time. So a stock will go up and down, sometimes many times over the course of a day, but certainly over longer periods of time.
And basically what he discovered was, that’s true and every stock does that, but they don’t do it at the same time, and it’s almost like if you think of two sine waves that are in opposite phase with each other, they will ultimately cancel each other out.
And even though it was not the case that these stocks were in opposite phase, as long as though they weren’t in exactly the same phase with each other, you still get some dampening effect.”
The final crucial piece of the puzzle came in the 1960s, with William Sharpe and other academics devising the Capital Asset Pricing Model.
No such a Modern Portfolio Theory now
Portfolio Theory and the Capital Asset Pricing Model now underpin most market analysis.
And latterly authors like Lars Kroijer have explained how the model implies that rather than try to pick stocks or invest in particularly skewed funds, ordinary investors are best off holding total market index trackers (something like the Vanguard World Index Fund) for the equity part of their portfolio, and vary their exposure to risk simply with cash and government bonds.
See his book Investing Demystified
Of course, not everyone agrees with the academics. Warren Buffett is one notable critic of the models.
But even he backs trackers as the best way forward for most investors.
It’s also interesting that many edge-seeking hedge funds start from the premise that markets are overwhelmingly efficient as implied by these theories, and then look for risk/reward discrepancies and mispricings.
Indeed Harry Markowitz himself co-founded one of the very first such quantitative hedge funds!
Check out the rest of the videos in this series so far.
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“A simple portfolio can be created with just a handful of funds, with your precise allocations tweaked to suit your temperament and attitude to risk.” I’m sure my portfolio should suit my purpose. But that purpose is rather hard to identify: maybe it boils down to my widow living in comfort and security until death. But for how long will she last? In what sort of world? In what sort of health?
I sometimes think I should be investing specifically against the risk of our defined benefit pensions failing, our state pensions being frozen or withdrawn, and the NHS dissolving because of the exponential growth of its costs and the incompetence of its bureaucracy. Could it really make sense to defend oneself from such an extreme combination? Or would it be bonkers not to defend ourselves from that, since we’re reasonably well defended against milder adverse conditions anyway? The secret of damn near everything is Purpose. It’s vexing when purpose is vague.