Not too long ago, newspapers had bulletproof competitive advantages, Campbell’s Soup had a powerful brand, and shopping malls attracted the highest rents. Now the opposite is true in each case. The changes came in largely unanticipated ways.
Nobody knows exactly how the future will unfold. A sound theory one day can be a lousy one the next. Karl Popper advised us to distinguish between a theory, which is an interpretation of the underlying truth based on the evidence we see at that moment in time, and the underlying truth itself. The two are different.
Richard Feynman described the creation of theories as a chess game where we don’t know the rules. We see snapshots of the board between moves. We make theories of the rules of the game based on those snapshots. We see two players taking turns moving pieces. We learn how the different pieces move. We think we have the rules all figured out. Then one player shows up with two queens. How is that possible?
As investors, we create theories. We claw and we scratch to develop theories that best describe the existing evidence. Just when we think we have it all figured out, someone shows up with two queens. The truth is, we cannot observe the rule book directly. We see evidence. We make theories based on that evidence, but theories by their very nature are uncertain. We never know exactly what the future has in store. We don’t have access to the rule book.
Asset managers worth their salt need to somehow account for the uncertainty inherent in their theories. A theory is an interpretation of the underlying reality, not the underlying reality itself. Shopping malls received top rents once upon a time. A theory that extrapolated those high rents indefinitely into the future was a bad one. Things change. Theories are proven wrong.
Therein lies the value of true diversification.
If we magically had perfect knowledge about the future, diversification would have no value. We would identify the investment with the highest return and invest in that one single investment. Why not? Adding a second investment to the portfolio would only reduce the returns of the portfolio overall.
But uncertainties exist. We add a second stock to the portfolio just in case we are wrong about the first. We add a third just in case we are wrong about the first two.
If the second and third stocks added to the portfolio each rely on the same investment theory as the first, the additional stocks don’t really protect the portfolio from being wrong about that one theory. They merely add to the number of stocks in the portfolio. A twenty-stock portfolio, in that way, can easily be more diverse than a hundred-stock portfolio if all the stocks in the hundred-stock portfolio share a common investment theory.
It is not the number of stocks in the portfolio that protects the portfolio from the uncertainties of the future, but the diversity of the investment theories behind the stocks. A portfolio that contains a collection of unique and independent investment theories is better protected from the uncertainties of the future than one whose investments all rely on the same theory.
The intellectual elite have tried and failed over the years to quantify portfolio diversification. Since true diversification - that is, diversification that protects the portfolio from the uncertainties of the future - depends on the diversity of theories in the portfolio rather than any quantifiable metric of the portfolio itself, the only real way to determine the diversification of a portfolio is the old fashioned way: to systematically identify and analyze the investment theories contained in the portfolio. If the investments in the portfolio all rely on a limited number of investment theories, that portfolio is not very diversified. If the investments in the portfolio rely on a diverse set of unique and independent investment theories, that portfolio is diversified. We have not yet found a reliable way to quantify true portfolio diversification.
At KP7, we do our best to construct a portfolio of undervalued securities backed by sound, independent, and unique investment theories. The more high-conviction, unique, and independent investment theories we come up with and include in the portfolio, the more diverse is the portfolio and the more protected the portfolio is against the uncertainties of the future.
