But isn’t the risk of diversifying compensated by a corresponding possibility of large reward if the sector outperforms? I wouldn’t consider a strategy that produces modest losses with high probability but large gains with low probability sufficient to disprove my claim.
Let’s go one step back on this, because I think our point of disagreement is earlier than I thought in that last comment.
The efficient market hypothesis does not claim that the profit on all securities has the same expectation value. EMH-believers don’t deny, for example, the empirically obvious fact that this expectation value is higher for insurances than for more predictable businesses. Also, you can always increase your risk and expected profit by leverage, i.e. by investing borrowed money.
This is because markets are risk-averse, so that on the same expectation value you get payed extra to except a higher standard deviation. Out- or underperforming the market is really easy by excepting more or less risk than it does on average. The claim is not that the expectation value will be the same for every security, only that the price of every security will be consistent with the same prices for risk and expected profit.
So if the EMH is true, you can not get a better deal on expected profit without also accepting higher risk and you can not get a higher risk premium than other people. But you still can get lots of different trade-offs between expected profit and risk.
Now can you do worse? Yes, because you can separate two types of risk.
Some risks are highly specific to individual companies. For example, a company may be in trouble if a key employee gets hit by a beer truck. That’s uncorrelated risk. Other risks affect the whole economy, like revolutions, asteroids or the boom-bust-cycle. That’s correlated risk.
Diversification can insure you against uncorrelated risk, because, by definition, it’s independent from the risk of other parts of your portfolio, so it’s extremely unlikely for many of your diverse investments to be affected at the same time. So if everyone is properly diversified, no one actually needs to bear uncorrelated risk. In an efficient market that means it doesn’t earn any compensation.
Correlated risk is not eliminated by diversification, because it is by definition the risk that affects all your diversified investments simultaneously.
So if you don’t diversify you are taking on uncorrelated risk without getting paid for it. If you do that you could get a strictly better deal by taking on a correlated risk of the same magnitude which you would get payed for. And since that is what the marked is doing on average, you can get a worse deal than it does.
But isn’t the risk of diversifying compensated by a corresponding possibility of large reward if the sector outperforms? I wouldn’t consider a strategy that produces modest losses with high probability but large gains with low probability sufficient to disprove my claim.
Let’s go one step back on this, because I think our point of disagreement is earlier than I thought in that last comment.
The efficient market hypothesis does not claim that the profit on all securities has the same expectation value. EMH-believers don’t deny, for example, the empirically obvious fact that this expectation value is higher for insurances than for more predictable businesses. Also, you can always increase your risk and expected profit by leverage, i.e. by investing borrowed money.
This is because markets are risk-averse, so that on the same expectation value you get payed extra to except a higher standard deviation. Out- or underperforming the market is really easy by excepting more or less risk than it does on average. The claim is not that the expectation value will be the same for every security, only that the price of every security will be consistent with the same prices for risk and expected profit.
So if the EMH is true, you can not get a better deal on expected profit without also accepting higher risk and you can not get a higher risk premium than other people. But you still can get lots of different trade-offs between expected profit and risk.
Now can you do worse? Yes, because you can separate two types of risk.
Some risks are highly specific to individual companies. For example, a company may be in trouble if a key employee gets hit by a beer truck. That’s uncorrelated risk. Other risks affect the whole economy, like revolutions, asteroids or the boom-bust-cycle. That’s correlated risk.
Diversification can insure you against uncorrelated risk, because, by definition, it’s independent from the risk of other parts of your portfolio, so it’s extremely unlikely for many of your diverse investments to be affected at the same time. So if everyone is properly diversified, no one actually needs to bear uncorrelated risk. In an efficient market that means it doesn’t earn any compensation.
Correlated risk is not eliminated by diversification, because it is by definition the risk that affects all your diversified investments simultaneously.
So if you don’t diversify you are taking on uncorrelated risk without getting paid for it. If you do that you could get a strictly better deal by taking on a correlated risk of the same magnitude which you would get payed for. And since that is what the marked is doing on average, you can get a worse deal than it does.