A large proportion of investors seek to diversify their portfolios. For example, they may hold different asset classes and a range of companies that operate in a wide variety of sectors.
Diversification can be helpful because it reduces risk. The impact of one company's performance on a portfolio is lessened if it makes up a smaller proportion of total value.
However, investors such as Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice-chairman Charlie Munger (Trades, Portfolio) have warned about the risks of diversification. It can lead an investor to buy unattractive stocks that detract from portfolio returns if they don't understand the business.
The 'cons' of diversification
Diversification can be problematic because it may lead to an inefficient allocation of capital. For example, an investor may only be able to find ten stocks that they believe are worth buying at a specific point in time. Rather than just holding them, they may believe they should add a further ten, or more, companies to their portfolio to reduce risk. The end result could be that the additional stocks they have purchased for diversification purposes deliver lower returns than the original ten companies they had identified.
In addition, diversification can make it more challenging for an investor to track their holdings. A smaller portfolio is, by its very nature, easier to monitor and re-assess to make sure current holdings continue to perform as expected. A smaller portfolio may also provide more time to find new stocks, rather than spending a large amount of time checking current holdings.
Charlie Munger (Trades, Portfolio) has previously stated his concerns regarding diversification:
"A lot of people think that if they have a hundred stocks they're investing more professionally than they are if they have four or five. I regard this as insanity. Absolute insanity. I find it much easier to find four or five investments where I have a pretty reasonable chance of being right that they're way above average. I think it's much easier to find five than it is to find a hundred. I call it diworsification—which I copied from somebody. I'm way more comfortable owning two or three stocks which I think I know something about and where I think I have an advantage."
The 'pros' of diversification
Of course, diversification can be a prudent strategy to adopt. Most importantly, it helps to reduce risk. The impact of one company's poor performance on the returns of an entire portfolio are dramatically reduced with even a little bit of diversification.
The pandemic has shown that unpredictable events can have significant impacts on company performance. For example, brick-and-mortar retailers have struggled because of containment measures that were unforeseeable by any investor ahead of time. Holding them as part of a concentrated portfolio could have led to significantly worse performance compared to a diverse portfolio.
In addition, the cost of buying and selling shares has fallen as internet sharedealing has become more popular. This assuages concerns previously raised by investors that diversification leads to dramatically higher costs that negatively impact on returns.
A balancing act
In my opinion, Munger has a valid point when he discusses the potential threats from diversification. It is never a sound idea to buy any stock exclusively for the purposes of diversifying. Likewise, having too many companies can make it difficult to know them in great detail, which is necessary to find the best value opportunities.
However, today's unpredictable outlook for many sectors means it is arguably more dangerous than ever to run a concentrated portfolio. One-off events can have a major impact on company performance and valuations. Therefore, in my view, having at least a degree of diversification in a portfolio is a necessity that could be a useful ally in the long run.
Disclosure: The author has no position in any stocks mentioned.
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