Against Diversification: A Suggested Strategy for the Know-Something Investor

Behavioral finance studies reinforce the idea of market inefficiency, suggesting that it is possible for informed investors to produce above-average returns on their investments. For “know-something” investors, portfolio diversification reduces risk at the expense of maximizing return, defeating the main purpose of investing in stocks. In psychological measurement terms, this practice resembles increasing a scale’s reliability at the expense of its validity. To illustrate this concept, 20 stockbrokers each created a portfolio of up to 20 stocks, separating their “top picks” from others in their portfolio. Results showed that portfolios of brokers’ “top picks” outperformed their diversified portfolios after a one-year period. While not statistically significant, results likely have great practical significance, and thus speak to the value of future studies on this topic.