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Comment by rrggrr | Hacker News Reader

A hedge fund manager once told me: "The only free lunch in my business is diversification". Her fund imploded three years later. There is no free lunch and portfolio theory is an inadequate hedge against theta decay and mean reversion.

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Are there any businesses that are a free lunch though? Most people lose money in finance, like tech startups and every other business I've seen where some of the people are making lots of money. Power laws at work.

You know what's even less conclusive than portfolio theory? Paul Graham essays and everything Steve Blank says.

There is no hedge against excessive leverage. Except of course being too big to fail.

You can't diversify a bad strategy, like selling cheap out of the money puts or picking nickels up in front of a steamroller with lots of leverage.

If you somehow have uncorrelated good strategies it's the best free lunch you'll get.

Diversifying using uncorrelated income streams is a good strategy, generally and there is actual math to show that you cannot significantly reduce risk by diversifying to more than ~20 streams.

Where could one read up more about this math showing you cannot significantly reduce risk by diversifying more than ~20 streams?

Unfortunately, I learned it on the job way back though I will keep an eye out of I see it.

I've also heard of using 30 (not 20) stocks as a sort of rule of thumb for sufficient diversification. I went ahead and looked it up though:

In 1970, Lawrence Fisher and James H. Lorie released "Some Studies of Variability of Returns on Investments In Common Stocks" published in The Journal Of Business on the "reduction of return scattering" as a result of the number of stocks in a portfolio. They found that a randomly created portfolio of 32 stocks could reduce the distribution by 95%, compared to a portfolio of the entire New York Stock Exchange. From this study came the mythical legend that "95% of the benefit of diversification is captured with a 30 stock portfolio."

http://www.investopedia.com/articles/stocks/11/illusion-of-d...

I would really read the rest of that link though, there's some good stuff in there.

This is about minimizing stock idiosyncratic risk, to capture market beta; there are many other asset classes one could put in a portfolio, diversifying the risks of market beta away.

The post said 20 uncorrelated income streams, not random stocks. Random stocks often have high correlations to each other.

Ben Graham and Buffett think diversifying increases risk. How well can you know one girl if your harem has thirty?

Statistical models are just models, not the real world.

Graham and Buffett are investors in the truest sense: they invest in the business, not in the stock. They deal with the managers directly. That is not what most of us do. That is why diversifying in such a situation increases risk: you only have so much mental attention.

No. Graham was a stock market investor. Buffett never bought a company till nearly 20 years into his career. Buffett and Munger believe in focused portfolios when you are investing in stocks, why put 5% into your 20th best idea when you can put 10% in your 10th best idea?

In reality most of us should not buy public equities, we should be in index funds.

Wouldn't that depend on the risk profile of those streams? There was a Bloomberg article a few weeks back showing that, like VC, hedge fund managers underperform the market because they tend to not be invested in the few outliers that are raising the mean.

Imagine hand waving here. This is from memory and there are certainly details missing.

Where can one find those elusive uncorrelated income streams?

Haha, I'd have my own fund if I was that good.

Heresay: A friend managed a hedge fund for a while. He said most of his peers didn't understand the math (the measures of volatility). Of course, I don't either; but I don't pretend I do.

The measures of volatility are backwards looking, and useless for the Buffetts of the world, who view volatility as opportunity, not risk.

She was playing options?

No. She ran a fund of funds.

you can't find safety in diversifying if it's also loading up on higher layers of fees.

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