That diversification is important is investing’s biggest truism. That said, not all diversification is created equal; some types are better than others. At one extreme, there is so-called random or naïve diversification, where no thought is given to comparing the components of a portfolio. By and large, this is how an insurance company behaves when it builds a portfolio of motor policies. It insures lots of similar risks, but it can still make money because it relies on the law of large numbers to guide its pricing. This is a powerful force in statistics, which tells us that the larger a data sample, the more likely that its average value will come close to its expected value.
So if industry-wide data tells an insurer that the claims rate on a type of motor cover will be one in 100 policies per year, the more policies of that type the insurer underwrites, the more likely that its claims experience will tally with prior probabilities.
Working along those lines can go some way in securities investing. Yet in a crucial way, a portfolio of stocks is different from a pile of motor insurance policies – the value of the stocks can rise and fall, the value of the motor policies can’t. That factor – the ability of stock prices to rise and fall – prompted one of the great insights in the history of finance: that it is not simply diversification that matters, but how an investor diversifies.