Diversification: separating volatility and dissimilarity

If investing were like dessert, would you find diversification with the 31 varieties of ice cream at Baskin-Robbins? or merely variety? What about at the supermarket? Hmmm.... Thoughts on a powerful word with two confusing meanings.

As a non-professional in the world of investing and finance, I often find myself having to decode what various words and concepts mean, a feat that is tougher when there is ambiguity in how others (including professionals) use those words and concepts.

I sometimes find myself wishing for something like the old Académie Française, which starting in 1635 (!), took on the role of regulating the official French language. Its power and influence is minimal now, probably for good reason, but for hundreds of years, it declared what was proper French, and what was not. Is it “Le Week-end”, “Le Weekend” or what about the traditional “la fin de semaine”? Nowadays, people just use the first or the second, but back in the day, you would know which of the three was the one to use (would have been the third, for sure).

Imagine a powerful version of that now for investing. First word to make a pronouncement about just has to be “diversification.”

It is simply maddening how many ways the term is used, and while I’ll stop short of declaring which is the “right” way, I do think some consistency would go a long way to make things make sense. As I see it, there are two main senses of the concept.

The first is “variety” by which people mean having an assortment of assets, often in the same asset class. This interpretation comes across when you hear someone say “buy European equities for diversification” or “diversify your portfolio by adding a tech fund.” These are not by themselves bad ideas; I think owning equities from different countries and from different sectors is great. Holding a variety of equities helps lessen idiosyncratic risk, or the specific risk that every asset carries. Being sure to not get stuck in just one sector helps avoid sector risk.

But, it’s not really diversification in a meaningful sense of the word if those things act like the equities you already have in those portfolios. European stocks are great, but they are also highly correlated with US stocks (.89 correlation since 2007). If you have VOO, itself already with huge positions in tech stocks, adding more may boost returns, but it would actually concentrate your risk in the tech sector, not diversify it.

Variety is a bit like Baskin-Robbins ice cream parlors: having a choice of 31 flavors is fantastic, and you don’t have to make the choice between old favorites or new experimental flavors. I like ice cream, you like ice cream, and we all scream for lots of choices with ice cream, for sure.

The other sense of diversification is “dissimilarity,” or the way in which assets behave differently from each other. You hear this sense when Risk Parity advocates talk about searching for new uncorrelated asset streams (like managed futures) or increasing allocations to Long-term Treasury bonds to find a source of positive returns that is (usually!) different from equities. While it is possible that different asset classes can both go down at the same time, such as in 2022 so far, they usually don’t since they are sensitive to different risks.

To me, this is true diversification, where combining unrelated or dissimilar assets fundamentally changes a portfolio and not the “Country AND Western diversification” that people usually get.

To return to the ice cream metaphor, you get a lot of variety at Baskin-Robbins, but it’s still all ice cream, even if you make a milkshake out of it or add hot fudge to make a sundae. Dissimilarity would be a bit like when you decide to get dessert by stopping off at the supermarket. You can decide to buy a birthday cake, get a dozen donuts, a pre-cut fruit salad, or the raw ingredients to literally make thousands of different desserts. You’ll probably also find at least 31 different flavors of ice cream to boot. The magic in portfolios comes from combining dissimilar assets, not just having a lot of versions of the same thing.

I may be on an island on this, but I think it would all be a bit more logical if we could decide on what these terms mean, and then stick to them. If diversification is too powerful a term to be adopted by either side, a good compromise might be to just use variety and dissimilarity, instead. I know, I know, not gonna happen, and this will frustrate me ever more….but still.