Before getting to fake fireplaces, consider the question: Does portfolio diversification work?
That is not a rhetorical question. I’ve heard plenty of people declare that portfolio diversification doesn’t work.
Not just any people, mind you, but I’ve heard plenty of investment professionals decry portfolio diversification as useless. “It doesn’t work,” they say. Their evidence? The market decline in 2008/2009.
Whenever I hear people declare that portfolio diversification doesn’t work, I don’t argue. Not because I agree with them, but because I’m chuckling, reliving a memory. The phrase “doesn’t work” transports me back to my first apartment. After graduating college I lived in Lincoln Park, in the North Side of Chicago, with my buddy Ross. Our apartment had a nice decorative fireplace with a marble facade. (That’s an actual photo of the living room, courtesy of Trulia.)
When guests would visit our apartment for the first time, invariably an exchange like this would ensue.
Visitor: (gesturing toward the fireplace) “Nice fireplace. Does it work?”
Ross: “That depends on what you want it to do.”
Ross was right. If you wanted it to host a fire, it didn’t work. (Trust me. Ross tried – but that’s another story). If you wanted the fireplace to dress up the room, make the room look good, more interesting, it worked.
So it goes for diversification. If you want diversification to insure your portfolio against losses, then by your definition it doesn’t work. But if you want to minimize the impact of idiosyncratic (aka diversifiable) risk, of course it works. For the purpose of reducing idiosyncratic risk diversification works brilliantly.
A: Whether portfolio diversification works depends on what you want it to do.
