Diversification or diworsification?
You might have surely heard debates about two different investment strategies: the concentration of the investments vs the diversification of the investment. The debate could seem merely entertaining. After all, we have all heard the old adage about “not placing all eggs in one basket”, right? While I have no doubt about the merits of diversification, I still believe we can learn a lot from both approaches.
The case for Concentration
A) Charlie Munger observed that in the wealth management space “a lot of people think if they have 100 stocks, they’re investing more professionally than they are if they have four or five. I regard this as insanity. Absolute insanity,” Munger said. “I think it’s much easier to find five than it is to find 100,” the 97-year-old investor argued. “I think the people who argue for all this diversification, by the way, I call it “diworsification”. And I’m way more comfortable owning two or three stocks which I think I know something about and where I think I have an advantage.”
The term “diworsification” has now become popular and widely used. It was coined by Peter Lynch in his book “One up on Wall Street” to lament that some companies expand into areas widely different from their core business, ultimately to their detriment. In relation to financial markets, Investopedia defines it as:
the process of adding investments to a portfolio in such a way that the risk-return tradeoff is worsened. Diworsification occurs from investing in too many assets with similar correlations that add unnecessary risk to a portfolio without the benefit of higher returns.
B) Diversification can clearly dilute your funds among non-performing assets. As such, the case for diversification is among quality complementary assets; diversification should not be about taking a shot at everything that is out there (low-quality assets, fads/hypes, highly speculative and/or un-tested products).
C) Conservative investors tend to use broad diversification to justify higher exposure to risk in untested areas, but diversification is not a guarantee against loss, but only against losing everything at once (Against the Gods. Peter Bernstein). As such, don’t overestimate diversification.
The case for diversification
A) The point of diversification is to reduce the risk of catastrophic loss by not having all of your funds in one investment. It doesn’t mean you will never experience a market downturn or a loss. You should be in a broad range of both fixed income and equity asset classes held in a mix that is appropriate for the amount of risk/volatility you can accept in your portfolio.
B) Professor Markowitz believed that diversification across a large number of securities made an overall portfolio less risky and that investors should really only care about the performance of their portfolio, not individual securities within the portfolio.
C) There is limited evidence of investors with the capacity to consistently perform a highly concentrated portfolio not associated with a disproportionate level of risk. Sure, you can name a few, but the selected group would not be statistically relevant and would be subject to survivorship bias. For the retail investor, diversification historically and technically offers the best risk-return model.
D) There is clear evidence that even professional investors are not able to pick the right stock consistently. Unless you want to be a stock picker with a limited amount of your savings for education or entertainment purposes (i.e. fun money), you are better off investing your savings through broad low-cost index funds.
E) Munger’s partner Warren Buffett beautifully stated that:
Diversification is a hedge against ignorance. It is something to apply “when you don’t know what you are doing”. It is for the know-nothing investor.
In fact, Warren Buffett himself promotes the use of index funds among “average investors” that have no means to analyse and pick up single stocks properly (23 seconds Video interview).
As a matter of fact, Warren Buffett criticises diversification and Modern Portfolio Theory only if embraced and implemented by professional investors whose job should be to outperform the market. (Video: the case against diversification, by Buffett and Munger).
F) Survival is key. Risk is something to be protected against, and diversification is the answer. But in so doing, diversification seizes surprising opportunities elsewhere. (Against the Gods. Peter Bernstein).
G) While focusing on the “return on the money”, make sure you also focus on “the return of the money”: keep a balanced risk-reward approach.
H) I view diversification not only as a survival strategy but as an aggressive strategy because the next windfall might come from a surprising place. (Peter Bernstein)
I) The ego is the enemy when investing. Most of the stock-picking excitement comes from the need to “beat the market”, to be better than the average investor. A wide diversified investment is less exposed to potentially higher returns of single stocks. Still, the role of long-term investment is to secure positive returns after inflation. Keep it simple, keep it boring.
J) Don’t only focus on the performance of financial investments. Instead of asking, “What should I do in my portfolio?” Ask, What should I do outside of my portfolio? Because, in the grand scheme of things, your investment portfolio is just one part of your financial picture. There are many other levers that you can pull if you want to improve your finances (saving rate, streams of income, lifestyle). (FS).
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