Diversification is protection against ignorance

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Professor Ron Bird, the director of a centre that studies capital market dysfunctionality, quotes world top investor Warren Buffett in his argument against stock diversification.

Buffet claimed that, “diversification is protection against ignorance”.

At the Paul Woolley Centre, Bird has been heavily involved in four studies conducted over the past three years that focus on behaviour within fund management firms and how they translate into performance for clients.

“Basically what it says is that diversification is just for the ignorant, which is possibly news to people,” he told Wealth Professional. “I don’t think there’s been evidence of some of these things in the past, and diversification is even embedded in law now – if you didn’t diversify your portfolio as a trustee you’d probably be in trouble.”

But quite simply, those in financial services should not “glorify” diversification, Bird said.

Fund managers do tend to have the ability to select up to five well-performing stocks; however after number five, performance starts to drop considerably.

For this reason a good fund manager will hold stocks they are confident in and not obsess about building a diversified strategy, he said.

Even then, Bird is critical about whether skills are actually required to perform well as a fund manager.

“So much of it is luck that even if you were a very bad manager you would have a one in three chance of getting sufficiently good performance to attract a fair amount of money,” he said. “So it’s an industry that doesn’t discourage people who are not very good at being part of it.”

Bird, who himself is a former fund manager and consultant for Towers Perrin, said he’s only met a handful of people who he’d actually consider good at the job.

At Towers Perrin he used to ask three simple questions of fund managers:
 
  • Why is the market you operate in inefficient?
  • How does your process exploit these inefficiencies?
  • Why will this continue into the future?
“Half of them didn’t have any idea – they hadn’t even thought about it, which is scary,” he said. “People who do well at this have very pre-defined ideas about how markets work and don’t depart from it even when they are doing badly.”

Another interesting revelation that came out of the study at the Paul Woolley Centre was that personality traits and behaviour of fund managers are actually the best predictors of future performance.

Those who tend to take bigger portfolio and industry bets and ignore any market announcements actually do better.

“Evidence strongly supports that managers who behave as though they are above average, achieve the best performance,” Bird said.

This gives insight in what people should look for when hiring a manager, he said. It’s better to select a smaller, new or boutique-type manager with a reasonable portfolio and confidence galore.

But that’s only if you don’t have the resources to do the investing yourself and even gain something unexpected, he said, using the huge growth in the SMSF sector as an example.

“This is popular because it’s not simply an investment opportunity, it’s for consumption. People get enjoyment out of it, just like going to the races. People often lose sight of the fact that investment is not just an opportunity to make money,” he said. “Get the best ideas from the professionals and then put them together in a portfolio so you’re not giving your money to managers and just telling them to ‘diversify’…All fund managers are doing is transferring wealth from one person to another and taking a cut along the way.”

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  • SB on 16/05/2014 9:45:04 AM

    "All fund managers are doing is transferring wealth from one person to another and taking a cut along the way.”
    So those "best ideas" you have just told us to get from managers and then implement ourselves have no value? I always thought the "cut along the way" was just the price for these good ideas.

  • Investor on 16/05/2014 10:37:25 AM

    Sounds to me like he has a chip on his shoulder. There are many reasons why it is extremely difficult to beat the market. there are some strategies that improve your chances in the long term. However will your clients stick with you until the strategy works. To have consistent out performance, you would need to be a market psychologist. In the short term it’s all market sentiment, longer term its market fundamentals. So longer term, get the fundamentals right and you can beat the market. But all your clients may have left you by that time.

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