Diversification is one of the essential principles of portfolio construction.
Unfortunately, it also seems to be one of the most misunderstood.
Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.
Investors can never be 100% sure that a particular asset will generate a positive return. (We can’t, for example, positively identify 100% of frauds).
But we can use diversification to reduce the impact a negative outcome will have on overall performance.
However, the water has been muddied by the comments of well-known investors who have advised against using a diversified portfolio.
Warren Buffett on diversification
Warren Buffett has famously said he is against diversification.
“Diversification is a protection against ignorance,” Buffett once said. “[It] makes very little sense for those who know what they’re doing.”
Following this approach could expose investors to significant danger.
Granted, it is correct that many of the world’s most successful investors have earned the bulk of their profits from just a handful of firms. So have many successful businesses owners. But, the figures are highly skewed by survivorship bias.
Yes, Buffett has made billions concentrating his funds in a handful of stocks.
However, many thousands of other investors have not been so lucky.
A few years ago, a group of Wall Street analysts published a report looking at the performance of individual stocks over the past few decades. They found that just 4% of the stocks in the S&P 500 accounted for all of the index’s performance. When you flip the figures round, that means 96% of stocks generated sub-par returns.
In my opinion, this information illustrates why diversification is so important.
If one follows Buffett’s advice and buys just a handful of stocks, there’s a 96% chance these investments will yield sub-par returns. The possibility of the stocks outperforming is around 4%.
That’s not to say Buffett’s advice should be overlooked. It is worth considering, although one needs to view it in context.
Strengths and weaknesses
Buffett has said diversification is a protection against ignorance. He’s also admitted luck has paid a large part in his success. Luck and research. The billionaire has revealed he read 100 years of Coca-Cola’s annual reports before investing in the business.
The fact of the matter is, 96% of investors won’t have luck on their side. What’s more, most non-professional investors won’t have the time to read 100 years of annual reports.
It’s important to acknowledge these differences. Just because Buffett (and other well-known investors) follow one path does not mean you have to as well.
Investors need to recognise their weaknesses as well as strengths and build a strategy that suits their own levels of understanding, insight, risk tolerance and financial position.
Blindingly following others may only lead to disaster.