What Merry Wives of Windsor says about over-diversification

The Merry Wives of Windsor is a comedy written by Shakespeare around 1602, reputedly on the suggestion of Queen Elizabeth I, who liked the character of Sir John Falstaff in Henry IV Parts 1 and 2. In Merry Wives, Falstaff tries to make some easy money by seducing the wives of wealthy merchants.

However, the plan backfires: the women aren't interested in him, while his servants (whom he fires after they refuse to deliver his letters) tell their husbands of his plans. During the resulting escapades, Falstaff ends up thrust into a series of embarrassing situations, including being thrown into a river and having to dress up as a woman.

The key moment

To increase his chances of success, Falstaff sends the same letter to two different women, Mistress Ford and Mistress Page. He boasts that "I will be cheater to them both, and they shall be exchequers to me; they shall be my East and West Indies, and I will trade to them both". But he overlooks that the women are friends and so they compare letters. As a result, they are even more annoyed by the brazenness of his strategy, and decide to teach him a lesson, rather than just ignoring him.

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Lesson for investors

In reality, attempts to diversify your portfolio are unlikely to backfire as spectacularly as they do for Falstaff in the play. Still, increasing the number of stocks in your portfolio means you have to keep track of more companies. It also means that you have less of your portfolio invested in your highest-conviction ideas, and you may be forced to include stocks that you are not particularly enthusiastic about, which is likely to hurt your returns.

A study by Danny Yeung of the University of Technology in Sydney found that fund managers who limited their portfolios to a smaller number of key stocks did better than those who spread their investments more widely.

Other financial wisdom

Any trader could tell you that Falstaff's other big mistake was attempting to stick with his plan after his first major mishap. Because the stockmarket tends to have short-term momentum, doubling down on losing trades is rarely successful. Even for long-term investors it is worth considering whether you should close a position after it falls from the initial buying price by a set amount (eg 20%-30%).