Nobel-prize winning economist Harry Markowitz wrote that “diversification is the only free lunch in finance”. A free lunch sounds good, but the reality is often bland sandwiches, a plate of crisps and lukewarm coffee. Private investors do not need to diversify as much as they think.
Diversification is conventional wisdom. The idea makes a lot of sense: by diversifying across a broad range of assets an investor can reduce both risk and volatility. For those who are risk-averse or are coming to their autumn years, this strategy can certainly help one sleep at night.
However, everything in life is a trade. Reduced volatility means downside is protected, but upside is diluted. And when it comes to risk reduction, although specific asset risk is reduced it doesn’t matter how diversified you are in a bear market. Nearly everything falls. I believe private investors are sold diversification as a hedge against downside risk. But they can achieve similar hedging through buying a smaller number of non-correlated stocks, without stunting their upside.