Not long ago, children used to be viewed as a form of wealth. As a result, men would marry many wives who would then sire a lot of children. These children would then be used as a form of labor in farming their extensive fields. Hence the more children a family had, the wealthier they were considered.
Not only was siring a lot of children a form of generating wealth but also a form of insurance. Not long ago, the death rates of children were higher due to poor pre and post maternal care, and the advancements in medicine and technology that we enjoy today were yet to be imagined.
As a result, families would sire several children, knowing that some of them would not make it to adulthood. Hence they would still have other children who would help them till their lands.
As you can see, even before money was the main medium of exchange, the concept of diversification was already engrossed in the thinking and behavior of mankind.
Turning the leaf to investing, diversification is no different. According to Investopedia, diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories.
“Diversification doesn’t depend on how many investments you have. It depends on how different your investments are from each other.”Jason Zweig
The Essence of Diversification
As a rule of thumb in investing, you should never put all your money in one investment no matter how sure you are that it will be a winner.
As they say, diversification is the only free lunch in investing, and for a good reason. People who shun diversification are people who think too much about returns and think less about risk. When things go well when you are not diversified, the upside is huge. The opposite is not only true but worse. You may lose everything when the only asset you had put all your money in crashes.
“Whenever people start questioning the value of diversification- overconcentration and overconfidence must be on the rise, and the risk of being under diversified is likely to materialize.”Jason Zweig
Diversification is Not How You Build Wealth
One mistake that newbie investors make when they are trying to build their wealth through investing is casting their net too wide. What they do not realize is that diversification is not how you build wealth. It’s how you preserve wealth.
Concentration is how you build wealth. This is by putting your money in a few “sure bets” that you think have the greatest possibility of doing well.
Diversification may preserve wealth, but it’s concentration that builds wealth. When you get too diversified at the beginning of your investing journey, you are indirectly changing your goal from building wealth to preserving wealth. The wealth which you are yet to amass.
Just like what happens when you overdose on your prescribed drugs from your health practitioner, there are similar effects in investing when you over-diversify.
Your portfolio will not do well as your winners will be taken down by your losers.
Diversifying for Diversity’s Sake
If you look at how many investors approach diversification, they just buy several different companies that they have not studied well just for the sake of diversification.
As Peter Lynch, the author of One Up On Wall street, wrote,
“There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors.
That said, it isn’t safe to own just one stock, because, in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios, I’d be more comfortable owning between three and ten stocks.”
Warren Buffett On Diversification
Warren Buffett is the world’s most successful investor. He is a genius in stock picking. He has been able to pick well-performing companies for decades. For a man who pays very keen attention to how he picks his stocks and who gets it right more often than the normal person, here’s what he has to say about diversification.
“Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing. Wide diversification is only required when investors do not understand what they are doing.”Warren Buffett
Warren Buffett understands what very few investors understand. It’s through concentration that you can build wealth as an investor, not through diversification.
When you cast your net too wide, some of the companies you overlooked will lower the gains made by your well-performing stocks.
Instead of looking for a reason to add a company to your portfolio. Look for reasons that could lead to you removing a company from your portfolio. That way, you will end up settling with your few “sure bets.”
As Warren Buffett wrote,
“The strategy we have adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors.”
We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying it.”
When thinking about diversification, you are considering two things: risk and return. You want to come up with a plan where you spread your risk while at the same time not lowering your return as much.
As much as diversification is important in spreading risk across different assets, don’t just diversify for the sake of diversity. For if yours is diversification for diversity’s sake, then wealth creation will elude you.