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A hedge fund manager once told me: "The only free lunch in my business is diversification". Her fund imploded three years later. There is no free lunch and port
by rrggrr 9y ago
A hedge fund manager once told me: "The only free lunch in my business is diversification". Her fund imploded three years later. There is no free lunch and portfolio theory is an inadequate hedge against theta decay and mean reversion.
- cheez 9y agoDiversifying using uncorrelated income streams is a good strategy, generally and there is actual math to show that you cannot significantly reduce risk by diversifying to more than ~20 streams.
- kovek 9y agoWhere could one read up more about this math showing you cannot significantly reduce risk by diversifying more than ~20 streams?
- cheez 9y agoUnfortunately, I learned it on the job way back though I will keep an eye out of I see it.
- frgtpsswrdlame 9y agoI've also heard of using 30 (not 20) stocks as a sort of rule of thumb for sufficient diversification. I went ahead and looked it up though: In 1970, Lawrence Fisher and James H. Lorie released "Some Studies of Variability of Returns on Investments In Common Stocks" published in The Journal Of Business on the "reduction of return scattering" as a result of the number of stocks in a portfolio. They found that a randomly created portfolio of 32 stocks could reduce the distribution by 95%, compared to a portfolio of the entire New York Stock Exchange. From this study came the mythical legend that "95% of the benefit of diversification is captured with a 30 stock portfolio." http://www.investopedia.com/articles/stocks/11/illusion-of-diversification.asp http://www.investopedia.com/articles/stocks/11/illusion-of-d... I would really read the rest of that link though, there's some good stuff in there.
- tanderson92 9y agoThis is about minimizing stock idiosyncratic risk, to capture market beta; there are many other asset classes one could put in a portfolio, diversifying the risks of market beta away.
- dtwest 9y agoThe post said 20 uncorrelated income streams, not random stocks. Random stocks often have high correlations to each other.
- valuearb 9y agoBen Graham and Buffett think diversifying increases risk. How well can you know one girl if your harem has thirty? Statistical models are just models, not the real world.
- cheez 9y agoGraham and Buffett are investors in the truest sense: they invest in the business, not in the stock. They deal with the managers directly. That is not what most of us do. That is why diversifying in such a situation increases risk: you only have so much mental attention.
- valuearb 9y agoNo. Graham was a stock market investor. Buffett never bought a company till nearly 20 years into his career. Buffett and Munger believe in focused portfolios when you are investing in stocks, why put 5% into your 20th best idea when you can put 10% in your 10th best idea? In reality most of us should not buy public equities, we should be in index funds.
- rdlecler1 9y agoWouldn't that depend on the risk profile of those streams? There was a Bloomberg article a few weeks back showing that, like VC, hedge fund managers underperform the market because they tend to not be invested in the few outliers that are raising the mean.
- cheez 9y agoImagine hand waving here. This is from memory and there are certainly details missing.
- marcosdumay 9y agoWhere can one find those elusive uncorrelated income streams?
- cheez 9y agoHaha, I'd have my own fund if I was that good.
- dave_sullivan 9y agoAre there any businesses that are a free lunch though? Most people lose money in finance, like tech startups and every other business I've seen where some of the people are making lots of money. Power laws at work. You know what's even less conclusive than portfolio theory? Paul Graham essays and everything Steve Blank says.
- nissimk 9y agoThere is no hedge against excessive leverage. Except of course being too big to fail.
- smrtinsert 9y agoShe was playing options?
- RockyMcNuts 9y agoYou can't diversify a bad strategy, like selling cheap out of the money puts or picking nickels up in front of a steamroller with lots of leverage. If you somehow have uncorrelated good strategies it's the best free lunch you'll get.
- specialist 9y agoHeresay: A friend managed a hedge fund for a while. He said most of his peers didn't understand the math (the measures of volatility). Of course, I don't either; but I don't pretend I do.
- valuearb 9y agoThe measures of volatility are backwards looking, and useless for the Buffetts of the world, who view volatility as opportunity, not risk.