Individual Investors Should Not Abandon Their Competitive Advantage in Favor of Diversification

The possibilities offered by contemporary financial markets, that is — the opportunity for a broad portfolio diversification by investing in different financial instruments with ease — is not the blessing that those who profit from the variety of financial services and instruments would have you believe. In many cases, this kind of “diversification” is not only useless, but risky for individual investors.

Individual investors' diversification - Investment advice

The TradersEXPO New York, 2017

Thoughts about diversification, which is widely accepted both in an academic environment and among investment advisors as an unmitigated good and a “free lunch,” kept running through my mind while at the TradeEXPO New York. Seeing different financial instruments, as well as trading and investment techniques, and even talking to company representatives, I kept thinking about diversification – a topic that was the subject of frequent discussions I had with professors while I was a financial economics student. I will not focus here on the question of why diversification (quite a disputable concept, in my opinion) is so widely accepted in the investment community. This is a topic for a separate article. Instead I want to say a few words about what private investors lose when they adopt the idea of diversification as an indisputable truth.

Developing at Columbia University my investment approach, StockFollowing®, I was always amazed at private investors’ inclination to be wrong in the right way rather than to be right for the wrong reason. It was clear why investment companies, whose profit depends on the amount of assets under management, might act this way. Playing by the rules (even if this does not represent the best investment decisions) is, after all, their dominant strategy, one that also provides a natural protection from possible lawsuits in case something goes south. But what makes private investors, managing their own money, play the same game?

My six years’ research in investment psychology and the influence of the human factor on investment decision-making had demonstrated that individual investors indeed pay more attention to the correctness of the investment process (the cornerstone of which is the idea of diversification) than to achieving the best possible investment results. Following the widely-accepted investment concepts may seem to be the way to go. But this has at its core a fundamental flaw. Following the crowd makes it difficult for individual investors to see a solution rendered as impossible by contemporary investment theories and models. Moreover, investment models do not take into account that individual investors holding small portfolios are more flexible in their investment decisions than investment funds. For example, those investors who are listening to everything Warren Buffett has to say miss the point that the strategies for investing $40 billion and $40k are vastly different. By following Buffett’s advice, private investors are not reducing their investment risks, as they tend to think, but are rather giving up their competitive advantage.

In my opinion, the first thing individual investors in the stock market should do is to stop thoughtlessly diversifying their investment portfolios and chasing “big name” advice. Instead, they should focus on the search for, or creation of their own investment strategy. That which, by taking into account individual investors’ inherent flexibility, could with minimum risk allow for an investment return higher than that of the S&P 500 index. By deciding to pursue results, each individual investor will soon come to realize that the diversity of financial information, services, and financial instruments is not, in fact, his or her ally. All that this diversity leads to is loss of the competitive advantage and dissipation of one’s efforts. In this sense, the possibilities offered by contemporary financial markets are not only useless, but risky to individual investors since they interfere with their ability to solve the only important problem, which is profit maximization.

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