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All Your Eggs in One Basket

Summary: 

Diversification is a very poor investment strategy for unpredictable R&D+. Once you get more than a handful of investments, further diversification worsens success rates. Better to pick a few high quality investments and keep all your attention focused on making those few successful.

Put all your eggs in one basket and watch that basket. Twain, Mark (1894). The Tragedy of Pudd'nhead Wilson

Don’t put all your eggs in one basket. This is the basis of investment diversification, the foundation of modern portfolio management theory. But then how many baskets? Probably two. It doesn't take broad diversification to achieve one's investment goals with a reasonable level of reward versus risk. For example, it would be silly to dilute a portfolio from owning five great stocks into owning thirty mediocre stocks.

Diversification is one of those oft-repeated mantras that gains an aura of truth simply from repetition. Diversification is not an empirical fact. It is most likely false, but it’s a handy crutch for individual investors and investment brokers. It’s an exaggeration+ of the advantages that come from having two baskets. The more baskets, the more the dilution of attention to each basket (but the higher the commissions paid to investment brokers).

Diversification of a stock portfolio to reduce risk works, but only up to a very limited number of stocks. Probably two. We illustrate this graphically in the case where risk is so high we might consider including four or five stocks in our portfolio (e.g., unpredictable R&D). Beyond this the number of investments per se has little impact on the actuarial outcome of a portfolio.


Success Rate per Investment. The more you diversify (add stocks to your portfolio) the less you earn as a percentage of your investment. In the case of unpredictable R&D, we estimate the optimal number of investments for the portfolio is in the range of four to six (per investment category).

With investments into unpredictable R&D+ we stop with a portfolio of four to five investments per category (e.g., pre-game+, mid-game+).1 We bundle investments not so much for diversification, rather for sharing of sources-and-uses of funds. Funds when they become unexpectedly available in any one investment are supplied across all other investments. Our supply and demand for funds for any one investment are unpredictable. Too much availability at once? We husband funds. Too many needs at once? We borrow against future (unpredictable) winnings. Sharing of winnings is a primary source of funding across our portfolio of investments.

Our bundling is a personal, not a quantitative exercise. The bundle sums up individual valuations. It is not a mask for lack of understanding of the intrinsic values of underlying assets+ (i.e., what killed securitized mortgages and their holders). There is no normal or bell curve. There are no alphas or betas. There are no ‘risk-discount’ factors. We control the market psychology that can lead to ‘the lemming effect’. Bundles do not experience inflated pricing nor do they ‘correct’ for inflation. Our bundle, the perpetual fund+ share, is a quasi-objective calculation. It sums up valuations of individual assets (updated constantly), and keeps the multipliers used in the calculation consistent from one valuation cycle to the next.

Diversification strategy is fundamentally flawed for investments into intellectual capital+ (e.g., unpredictable R&D). We not only prohibit this kind of thinking in our funding agency+, we prohibit the collection of data that gives rise to those who peddle it. We invest into high quality investments and value each investment individually. If value, wealth, is found in a movement of the minds of those who created the intellectual capital2, as reflected in the minds of those who assign value, then how does playing two or more of these mind games reduce investment risk? It seems a silly exercise, especially when you assign quantities to the risk. We reduce risk by keeping wealth-creating minds as healthy, committed and passionate as they can be.3 Citizen – investors have direct access to the levers of success for their investments (e.g., support of success assurance+ programs). They do not rely on anonymous surrogate measures of risk as invented whole cloth by the quants.


Editor's Picks for September, 2011

  • 1. Obviously investments come and go, so the actual numbers will be much higher.
  • 2. Investible Unit+ teams slowly internalize the concept of R&D effectiveness and this shows in their exploitation of the Science Platform.
  • 3. Mother Nature may leave the building, but this is radically unpredictable. You can’t assign percentages to this accident.
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Reba Tull
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Joined: 03/30/2011
Diversification may be misused, but it's still a valid approach

The investment community, except a few contrarian investors, has not abandoned diversification as one of its pillars of investing despite the 2008 market failure. Instead they argue for more sophistication in diversification of the portfolio. Diversification was tainted by investors being too simplistic in selecting their baskets, i.e., without considering the manufacturer of those baskets. They got into trouble because all their baskets contained a few rotten eggs (e.g., investments overly reliant on securitized mortgages). It’s going to be impossible to erase this way of thinking from investor mindsets.