Is Portfolio Diversification a good thing?
Conventional wisdom is that diversification in a portfolio is a good thing, and is a common mantra according to modern portfolio theory. Financial advisors will often preach the benefits of having a “well diversified portfolio”. That said many famous investors such as Warren Buffet and George Soros have created wealth through concentrated strategies not diversified strategies, and their approach has been supported by several empirical studies. According to Buffet:
“Diversification is something that people do to protect themselves from their own stupidity.”
- Warren Buffet
What Buffet means is that due to a lack of intelligence and expertise to make large investments in just a few businesses, people hedge against their own ignorance by having their capital spread out amongst different investments. The shortfall of the diversified strategy is that it becomes harder and harder to keep track of all the eggs in the different baskets. Amazingly, many intelligent people take a large portion of their wealth and invest in something they know nothing about, but will do a ton of research when doing relatively smaller purchases such as a new TV or a new pair of sneakers.
Meanwhile, the concentration portfolio approach means focusing on a small number of investments that you really understand and intend to hold for a long period of time. There are several studies that suggest the benefits of diversification as far as reducing risk are minimal after the tenth security. At this point there is marginal risk reduction. In conclusion, this does not mean that diversification is a bad thing, but rather diversification to a point of not understanding the businesses that you’re investing in is.