Myth of diversification as safety?Part 1: definition of risk

March 26th, 2007

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In our previous article, The ABCs of hedging, we said that the ?most well-known and basic technique [in hedging] is diversification.? We often hear from financial professionals that it is very essential because it is the means by which risks can be reduced. The principle behind this idea is to decrease the hazards to your investments by not putting all of them in one basket. As with many ideas in life, what started of with a sound base of principle gradually becomes a mantra with unsound indiscriminate applications. In this article, we will expose some of the myths with regards to the diversification.

First, how is risk defined? As we have mentioned before in How the folks in the finance industry got the idea of ?risk? wrong!:

… mathematical definitions of ?risk? [, which is often made by the finance industry] give it a scientific feel, which seem to give us the impression that ?risk? can be measured and controlled.

The problem with such precise measurement is that it is precisely wrong! By defining risk that way (see How do you define risk?), we are in effect letting price be the root determinant of ?risk!?

The next question to ask is this: what is the root assumption behind such definition of risk? We guess it is the famous Efficient Market Hypothesis (EMH), which asserts that prices ?already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects.? There are many serious reservations on EMH and personally, we doubt this theory is true. Furthermore, we doubt that prices follow a Bell curve (see How the folks in the finance industry got the idea of ?risk? wrong!) in the real world.

Since diversification is meant to reduce ?risk? and if ?risk? is wrongly defined, how useful do you think it is?

Stay tuned for more of our views on diversification!