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Musings on Diversification

Updated: Feb 14, 2019

I read an article this week that claimed just 6 stocks have accounted for all of the S&P 500’s returns thus far in 2018. Think about that, the remaining 494 stocks have returned 0%. On a more extreme level than Pareto’s Principle, just 1.2% of the stocks in the index made up 100% of the results (if you don’t want to click on the Pareto link, the principle states that about 80% of outputs come from 20% of inputs. For instance, as a rule of thumb, 80% of a business’s profits will come from 20% of its customers. This is definitely not a sure thing, but there are many examples, even from nature.)




Anyway, this observation leads into questions about diversification. Diversification is the spreading out of investments to decrease risk. If you have $10,000, spreading it evenly amongst 10 stocks is “less risky” than buying $10,000-worth of one stock. If that one stock crashes 50%, you lose 50%.


On the other hand, if you spread your bets 10 ways, a 50% loss in one stock results in a total portfolio loss of just 5%. Therefore, it makes sense that diversification decreases risk. This is how diversification works on paper. But we live in reality, and sometimes reality works out a little differently. Here are three reasons why diversification is not always the best idea.


Three Reasons Against Diversification


First, diversification leaves us with inevitable mediocrity. In our example, owning the laggard 494 stocks in the S&P 500 would leave you with nothing to show for. But in real life, owning 494 individual stocks is impractical. At a certain point, diversification becomes a burden. There’s no way you can learn about 494 companies unless you spend every waking moment doing research…with a staff of dozens of people. If you own that many stocks, you are bound to hold mediocre companies. Wouldn’t it be better to choose the best ones?


Second, diversification includes an opportunity cost. For every additional stock you add, you are implicitly not buying your best ideas. In other words, would you want to buy your 15th or 30th or 40th best idea for the sake of diversification or buy more of your best idea? When your stocks go up they don’t make that big of a difference in your total portfolio as well. The same math for the downside goes for the upside. Split evenly amongst 10 stocks, a $10,000 portfolio will increase 5% if one of the stocks increases by 50%.


Third, diversification may actually be more risky. Investing is all about knowledge of the companies you hold in your portfolio. Would you rather buy 500 stocks that you didn’t know a thing about or buy 5 stocks that you knew extremely well? The first option is diversification. The second option is so-called “risky.” But which one is actually riskier? If you don’t know anything about the companies you are investing in, how will you know when to sell if the company starts performing terribly?


Why is Diversification So Popular?


Diversification is the industry norm in investing circles. Why you ask?


Well, for one, the world is never certain. I would never advise holding just one stock because you never know what can happen. The CEO could be in an accident, the company could get exposed for an accounting scandal, anti-trust regulations, legislation that changes an industry. You just never know. But we also need to temper that fear with not being afraid to succeed. That phrase may seem a little strange but I think it gets at the heart of why diversification is so prevalent.


By spreading your bets out, you won’t fail but you also won’t go above and beyond. This makes sense though considering something called loss aversion.


Typically, people regret loss twice as much as missing out on gain. It goes back to the cave-man days. If you were out hunting a lion, you were definitely going to be more scared of dying than thinking about the upside of dinner for a few weeks. Our modern-day brains are wired the same way.


The Alternative to Diversification


Nonetheless, diversification soothes our fear of failure. But what’s the alternative to it?

Well, Warren Buffett got to the heart of it when he said,


“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

The alternative to diversification is concentration. As a corollary to the quip, “Don’t put all your eggs in one basket,” concentration would say, “Put all your eggs in a few baskets and then watch those baskets very closely.”


Concentrated Investing...


Concentration doesn’t accept mediocrity, it realizes the significance of opportunity cost and it can be less risky because it usually means a higher knowledge factor.


Four Caveats


First, just like Warren Buffett said, if you don’t know anything about stocks, diversification is important. I would advise just buying the S&P 500. But you also have to live with mediocrity. If you want to learn more about stocks so you can do away with extreme diversification, check out the journey and get on the path to life-changing returns. It’s not a get-rich-quick scheme, it’s just learning about business and investing. The more you learn, the better your odds of success.


Second, as stated above, don’t buy just one stock; you never know.


Third:

If you don’t know anything: buy the index.

If you know a bit: buy between 20-35 stocks.

As you become an expert: you can trim down your portfolio to what you are comfortable with.


Fourth, as a last caveat, invest in a manner suitable to your personality. If you really hate seeing losses in your portfolio, maybe your concentrated portfolio will hold a few more stocks?


To Sum It Up


Diversification works on paper and it works in our psyches because our brains are wired to hate losing. However, diversifying for the sake of diversification leads to mediocrity, opportunity cost and a lower knowledge factor. On the other hand, concentration gives you a chance at going above and beyond. The more you know, the more concentrated you can become because you will decrease your risk as you increase your knowledge. Keep in mind that we need to be humble and we can’t know everything though.


Author's Note: Keep reading below!