One of the biggest challenges everyday investors face is the problem of diversification.
The question of how much diversification is enough is not easy to answer. It will always depend on the investor's own personal level of risk tolerance and, more importantly, experience.
However, in my opinion, most of us small-time investors should have a diversified portfolio and should not put more than around 5% of our assets into a single position. As Warren Buffett (Trades, Portfolio) famously said:
"Diversification is a protection against ignorance. [It] makes very little sense for those who know what they're doing."
Investing and the role of luck
Quotes like the above can be incredibly misleading, as everyone wants to define themselves as someone who knows what they're doing. Additionally, while some wildly successful investors have made a lot of money by concentrating their investments in a handful of positions, others have lost a significant amount of money following the same approach.
The easiest way to reduce risk in an investment is with research. The more research an investor completes, the lower the chance of a negative surprise emerging at some point in the future.
Unfortunately, this only works up to a point. We need to acknowledge the role luck plays in investing. No matter how much research and analysis an investor completes, there will always be unknown unknowns - the running of the business is out of our hands. These are things we don't know we don't know. They should not be confused with known unknowns, which are things we know we don't know.
For example, I know it's impossible to predict macroeconomic factors such as interest rates. That's a known unknown. However, I had not even considered the prospect of a global pandemic until this point last year. As I had not considered the possibility of a pandemic, I had not even thought about the impact a pandemic might have on the companies I own in my portfolio. That made it an unknown unknown.
These unknown unknowns will always be a risk. It's virtually impossible to protect against them. That's something Benjamin Graham understood, which is why he always demanded a margin of safety when investing in a security. He wanted some form of insurance against unknown unknowns.
Graham also believed that an investor should always have a well-diversified portfolio. He recommended a minimum of 30 positions but often had far more when using a value strategy.
One of his followers, Walter Schloss, who used a similar process up to the 2000s, reportedly owned more than 100 positions at any one time. Such a strategy is designed as an insurance policy against unknowns and uncertainty.
How much is enough?
There's really no right or wrong answer to the question of how much diversification is enough. Still, when considering this question, we need to evaluate the roles luck and survivorship bias have in our understanding of the topic.
Many successful investors we know today, such as Buffett, have made a lot of money using a concentrated portfolio approach. But this is not the only strategy that has shown success.
How many thousands of individual investors have lost significant amounts of money following the same approach? It's unlikely we will ever know. Almost every week there is a story online about some individual who has lost their life savings by putting all of their money in one equity. Granted, there are usually other factors at play. Nevertheless, we need to consider this when thinking about diversification and exactly how much is too much and how little is too little.
Another thing to consider is connectedness. Buffett and other hedge fund managers can contact business owners and CEOs. They can push for changes or simply just influence the market. Smaller investors can't. Buffett can, and has, turned a losing investment into a winning one by getting involved with the business. It would be impossible for smaller investors to do anything like that.
Disclosure: The author owns no share mentioned.
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