To what extent is diversification useful?
One of the few “certainties” existing in financial markets is the positive effect of diversification on the profitability and risk of a portfolio. Having a series of assets that obtain positive returns from different markets or products (unrelated to each other) will add value to our portfolio, because if a source of profitability fails the others will continue to generate profitability, but until Point is this true?
Diversification is one of the axes on which the investment is moving, a mantra that we repeat and in which we believe blindly. Its positive effect is undeniable, both from a mathematical and intuitive point of view, given that by mere common sense we can conclude that this is true. It basically means that “not putting all the eggs in the same basket” will give us more joy than frights in the long run.
On the other hand, there is a negative side, because high diversification can pose great costs of opportunity for our portfolio and make our knowledge and analysis of the markets useless. Warren Buffet clearly expresses this quote:
Diversification is protection from ignorance. If you know what you do, there’s no point in diversifying
By diversifying we gradually eliminate the intrinsic risk of each of our assets by taking our portfolio to bear only systematic risk. This might seem like a positive thing but it actually gets against us. Defenders of extreme diversification defend themselves by saying that the intrinsic risk does not bring profitability since only the systematic risk is remunerated and any risk taken above it does not bring profitability, only risk.
This is not entirely true because from a theoretical and operational point of view it does not work that way. If we add many assets to our portfolio we will replace intrinsic risk by systematic, so that we will end “Indexándonos ” causing the results of the same to be correlated in a total way to the results of the reference indices. This will lead us to incur an operational error, since we will be supporting a series of costs (in shares, costs of C/V, maintenance, etc. and in funds of active management, high commissions of management) so that finally our portfolio is behaving of a Form extremely similar to the index.
All this will lead us to have a tracking Error near zero, so that our portfolio will not deviate from the movements of the markets, so our active management (selection of values, timing of entry etc.) not bring value, becoming passive, but yes that It will have costs both at the operational level (commissions) and time of composition and tracking of the portfolio, when we could have obtained the same indexándonos with a significantly lower cost, which will lead us to assume a cost of opportunity. (Here we could get into the debate about what is best, whether active or passive management, but that is another matter!)