Rule #1 Of Investing: Don’t Obey Rule #1

One of the first lessons in any course on investing will be about portfolio construction and the benefits of diversification, how to maximize expected return for a given level of risk. If assets are not correlated then as you add more and more of them to your portfolio you can maintain a decent expected return and reduce your risk. Colloquially, we say don’t put all your eggs into one basket.

Of course, that’s only theory. In practice there are many reasons why things don’t work out so nicely. Often that’s because stocks and other investments stubbornly refuse to do what they are told.

But can it ever be optimal to not even try to diversify? Should you ever do the exact opposite of Rule #1? You betcha.

As we’ll see people in banks and hedge funds are encouraged to not diversify, to instead concentrate risk. I don’t know whether this is explicit or instinctive.

Imagine the following scenario. It’s your first day as a trader at an investment bank. You’ve had a world-class university education in economics in, say, Chicago. There you learned about all kinds of theoretically marvellous trades and how to manage risk by diversifying.

You are being introduced to the rest of the trading team. You notice that all of the trades they are doing are strangely similar. It worries you a bit because it doesn’t look like they are diversifying much.

You are then shown your desk, with multiple screens, and told to start trading.

Being a decent person you naturally want to do the best for your bank and so you seek out some trades that are uncorrelated to those of your colleagues but which also have a high probability of success.

Let’s put some numbers to this. There are dozens of other traders all making the same trade, and this trade has a 50:50 chance of making or losing a large amount. You have a better, and independent, trade that has a 75% chance of doubling your money and 25% of losing it all.

What happens next?

There’s a 50% chance that all the other traders lose a vast amount of money. This is not great. They might lose their jobs. The bank might go under.

But there’s also a 50% chance that they’ll be heroes, and rewarded as such in bonuses.

Meanwhile your trade might make some money. More likely than the other traders, at 75%. So you are more likely to be a hero too. No! If the others lose and you win then you are too tiny to even be noticed. You won’t be able to save the bank. And certainly don’t expect a bonus.

You can see this in the following table. If the other traders lose then everyone is fired including you. You can only get a bonus if the traders and you both win, and that has a probability of 0.75 x 0.5 = 37.5%.

	Traders win (50%)	Traders Lose (50%)
You win (75%)	Bonuses all around!!! (37.5%)	All fired!!! (37.5%)
You lose (25%)	You are fired, other traders get bonuses (12.5%)	All fired!!! (12.5%)

No, the only way to get that bonus is to cling to the coattails of the other traders. Do the same trade as them and you have a larger 50% chance of that bonus.

Lose money when all around are making it, you’re fired. Make money when all around are losing it? Expect a big bonus? No way! Your profits will help to bail everyone else out and no one gets a bonus, even you. No, you should do the same as everyone else.

As Keynes said, “It is better to fail conventionally than to succeed unconventionally.”