Per the SEC's beginners' guide to investing, diversification is defined as:
“The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.”
And:
“A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents and possibly other asset categories, you will also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.”
Diversification is widely accepted as being the best practice of management in the asset management industry. Spreading investments across sectors, industries and stocks is the best way of limiting risk while improving the chances of investment success.
While most average investors are encouraged to diversify, the world’s most successful investors hardly ever follow this advice. The likes of Carl Icahn (Trades, Portfolio), Warren Buffett (Trades, Portfolio), Charlie Munger (Trades, Portfolio), George Soros (Trades, Portfolio), Benjamin Graham, Bill Ackman (Trades, Portfolio), David Tepper (Trades, Portfolio) and Seth Klarman (Trades, Portfolio), to name but a few, all run extremely concentrated portfolios. There is evidence to suggest  these investors’ performance figures are wholly a result of concentration.
Is it wise to diversify?
It is not just individual investors’ performance that benefit from individual winners, it is the whole market. For the period 1983 to 2008, the Russell 3000, which represents 98% of the investable market, returned around 10% a year, but the majority of these gains came from just a few stocks. Specifically, nearly 40% of stocks produced a negative return over this period, 20% of stocks went to zero and 64% of stocks underperformed the wider index. Only 10% of the index’s constituents produced returns of 500% or more during the period, meaning less than 10% actually beat the index on an annualized basis.
The evidence against diversification does not stop there. From 1926 through 2009, stocks (as measured by the CRSP total market index) returned 9.6% per year. If you excluded the top 10% of performers, the return would have been only 6.2%. If you eliminate the top 25%, the performance becomes slightly negative at -0.6%.
Another shocking statistic comes from CBS, which found in 2013 that of the 500 companies in the S&P 500 as of Oct. 1, 1990, only 302 (60.4%) were even still in existence 10 years later. Of the 302, only 79 (26.2%) beat the Vanguard 500 Index Fund.
By investing in the top-performing stocks of the past two decades, it will have been easy to have outperformed the wider market. That is why famous investors sprout quotes about concentrated investing, such as those below:
“For individuals, any holding of over 20 different stocks is a sign of financial incompetence”--Phil Fisher
“Diversification is the most destructive, overrated concept in our business. Look at George Soros (Trades, Portfolio), Carl Icahn (Trades, Portfolio), Warren Buffett (Trades, Portfolio). What do they have in common? they make huge concentrated investments. You need ruthless discipline. If the reason you invested changes, get the hell out and move on.”--Stanley Druckenmiller (Trades, Portfolio)
"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results"--Charlie Munger (Trades, Portfolio)
Unfortunately, for the average investor, the above quotes are almost entirely useless.
Most non-professional investors just do not have the time, money or financial knowledge to be able to invest without having a diversified portfolio. If they try to invest in just four or five key positions, as the figures above show, there is a near 70% chance the stocks chosen will either go to zero, produce a negative return or underperform the market.
Put simply, while the world’s most successful investors believe diversification is a waste of time, it is extremely important for the average investor. Without it, you are almost guaranteed to underperform in the long term or, in the worst case, lose everything.
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