Dr. Myron Scholes cautions about the problems with diversification strategies: putting your eggs in several baskets is fine, but all the
eggs can still break. View Transcript

Diversification is important to investors most of the time, but the problem with diversification is that it fails at time of shock. Diversify away the idiosyncratic risk, get rid of it. Then what are you left with? You’re left with the systematic risk, or the beta risk of the portfolio.

And so when we think about our technology to use that information, it’s these different and conditional volatilities that we use to stitch together the conditional distribution to create an unconditional distribution. So we get the forward distribution of risk essentially by stitching together all the probabilities, the local probabilities, and adding them all together to get the unconditional distribution. So when all the volatilities are the same, that’s a normal distribution, because the distribution is no different, you know, and the tails or the middle as the top. That when the market is telling us that the probability of loss is higher, so when probability of loss is higher, that distribution has a fatter tail to it, or more probability, or more density, and as you go into the money it has thinner tails. So since we like positive skewness and we don’t like negative skewness, if the expected tail gain is higher than the loss, that’s positive skewness, right? So we like those assets. We don’t like the ones where have expected tail loss is high relative to expected tail gain, so the optimizer would move away from those assets to those assets that have high expected tail gain to expected tail loss.

I think they happen infrequently and in measurement as they said in the past, but I think that there are myriad little tail events that are happening, and there are idiosyncratic tail events. I mean, you know, it’s not necessarily the case that it’s just based on broad markets.

The problem is that you think that you might be more diversified than you are, even to idiosyncratic, to diversifiable risk, or more systematic risk, or market risk, and so you don’t put all your eggs in one basket. I worry sometimes, you know, you have eggs in this basket, you have another basket on your arm, and a third basket on your arm, and similarly on each of your other arm, you have six baskets, all not putting all your eggs in one basket. But then you’re walking with all of the eggs, and you trip and fall, all the eggs break.

Friends of mine told me, “Myron, I was stupid to have such a large home on the banks of the Mississippi,” when I was at the University of Chicago. So I sold my large home on the banks of the Mississippi and I bought a small home one side and another small home on the other side of the Mississippi, so I was diversified … I diversified my risk. But I was diversified to idiosyncratic things like you know fire, or whatever, but certainly I wasn’t diversified to floods. So diversification is good for the idiosyncratic risk, but the systematic risk part, everyone suffers.

60-40 strategy, which is a strategy that is a static allocation strategy, is an average strategy. Again, it doesn’t take account of the fact that sometimes you’ll have very negative returns between bonds and stock, and sometimes you’ll have very positively correlated returns between bonds and stock. And so sometimes the risk of a 60-40 strategy is 90% growth assets, 10% bond. Sometimes it’s 80%, you know, sometimes it’s 30%. If the investor wants to risk manage their portfolio to keep it at target, then how can you be keeping at a target when sometimes your risk is equivalent to 90% stock and sometimes it’s equivalent to 30% stock? And so by adjusting the relative weights of equity and, or growth assets and bonds as opposed to keeping it static 60-40, will give you a better experience than just the static strategy. And so static strategies work if you don’t have information. You get average results, but average is average. We don’t want average results; we want superior results, superior compound results, superior compound return, superior terminal value. And if you use the market information to adjust the 60-40 strategy to move sometimes to only 30% in equities, and sometimes maybe 70% or 80% in equities, and achieve the same average risk level, or same target drawdown level but end up at a higher compound return, that’s a better strategy.