Diversification vs Concentration: The Great Debate.

“Diversification is protection against ignorance” – Warren Buffett

“Diversify. In stocks and bonds, as in much else, there is safety in numbers.” – Sir John Templeton

 

Don’t put all your eggs in one basket, diversify?

Or…

Put all your eggs in one basket and watch them closely?

Which advice should you listen to?

 

Frustrating isn’t it?

 

You have been reading all sorts of books on investing but still can’t nail down a method that suits you best? You get conflicting advise from ‘gurus’ and you just don’t know what to do? Or better yet, you have no idea how this affects your portfolio returns?

 

The truth is there is no definite answer.

 

But I hope by the end of this post, you will have a better picture of what suits you best and the tradeoffs between the 2 school of thoughts.

 

Diversification reduces both systematic risk and volatility but limits your potential for high returns. Most common investing advise is having a diversified investment portfolio; often echoed by financial advisors and brokers.

 

Let’s start first by answering this question, “Why is diversification a common practice advised by financial advisers and brokers?”.

 

An investing legend, Jim Rogers once said “Diversification is something stock brokers came up with to protect themselves, so they wouldn’t get sued for making bad investment choices for clients. Henry Ford never diversified, Bill Gates didn’t diversify. The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket.”

 

That’s a bold statement.

 

Is he right? Should you not take the advise of financial advisers and brokers?

 

Financial advisers and brokers provides advise to a broad range of retail investors with different risk profile, most are conservative investors while others are much more adventurous in seeking higher returns. Some investors just can’t stomach a 20% drawdown on their portfolios, or daily fluctuations on stock prices. Hence providing a “balanced” recommendation seems to be the easiest and safest route for them. Nothing wrong with that, after all their primary objective will always be capital preservation first.

 

To add on, the level of competency on personal finance and investing varies greatly among retail investors. Most are beginners (although they hate to admit it), who are just seeking alternative avenues to save for rainy days and retirement.

 

Commitment also plays a role, most retail investors work full time jobs and dedicate very little time to monitor their portfolios. These investors would not have time to update valuations on stocks after its quarterly earnings release or keep up with corporate actions and announcements.

 

With the rise of robo-advisers and passively managed portfolios, investing becomes alot easier and diversification becomes a widely accepted concept among retail investors.

 

But do you know that successful investors are mostly concentrated investors?

 

46 of the top 50 richest in Singapore made their fortunes in one industry.

 

Top 10 richest in Singapore created their wealth in only one industry.

 

 

piechart1.png
Berkshire Hathaway Equities portfolio: Top 5 largest holdings represents 59% of portfolio.

 

piechart2.png
Carl Icahn’s portfolio: 78% in Top 5 holdings.

 

So why do well known investors like Warren Buffett, Charlie Munger, Carl Icahn, Bill Ackman and George Soros adopt concentrated portfolios? One word: EXPERTISE.

 

Unlike retail investors, professional investors and entrepreneurs are experts in their field which is a by-product of thousands of hours committed to conducting extensive research and knowledge. In Warren Buffett’s words; these investors have developed a circle of competence in their respective fields over years of experience and learning.

 

Over decades of their lives, these investors have invested hours every single day learning about business models, industries, macro-economic cycles that puts them ahead of the investing crowd.

 

Not to mention that they have access to vast amount of resources and talent to help them manage their portfolios.

 

So if you had invested so much time, effort and resources, why wouldn’t you invest heavily on your best ideas? Why diversify into meaningless oblivion and dilute away potential returns?

 

However the question is; how do you know when to bet heavy in a company?

 

This is a question that only you can answer.

 

Concentrated investing is about having confidence in your best ideas, it is about self-belief in your work and research done on businesses.

 

It took years, if not decades for successful investors to develop such confidence and expertise.

 

So what is the best option for retail investors?

 

In my previous post here, I wrote about why retail investors should emulate Walter Schloss. He worked with Warren Buffett as a Securities Analyst but never adopted the concentration approach. When asked about Walter, Buffett said:

 

“Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over again. He owns many stocks than I do – and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.” 

 

My point here is this, diversification is key to wealth preservation. In your early days as an investor, it is crucial to prioritize capital protection first and avoid huge drawdowns in your portfolio. By doing this, it helps you stay calm and strong psychologically while you learn the ropes in investing. I can assure you that your investing journey is a long road ahead and there will be plenty of mistakes to learn from. You don’t want to pay a huge price for amateur mistakes and give up your investing dream leaving a psychological scar.

 

A famed trader once said “Novice traders trade 5 to 10 times too big. They are taking 5% to 10% risks on a trade they should be taking 1 to 2 percent risks.” – Bruce Kovner, founder of Caxton Associates.

 

Over time you will develop your circle of competence and expertise in certain companies and you can make better judgement on investments, that is when you can size up on best ideas and manage a concentrated portfolio.

 

I hope you are getting the message here; to achieve success in investing, one needs to be different from the crowd. You need to be committed to learning about investing, businesses and the economy. It will be a never-ending journey; you will constantly learn about the ever-changing business landscape and economy. While we all dream of generating sustainable market beating returns, it takes time and experience to achieve. One does not become an expert in real estate (for example) overnight, people learn from mistakes and work towards self improvement. Keeping a long term focus and persistence will prevail.

 

Knowledge is a compounding asset.

 

 

 

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