Investors, analysts and financial commentators all seem to be split on the topic of diversification. Some argue portfolios should not be overly diversified and should have just a few concentrated positions. On the other hand, some analysts and wealth managers might argue that portfolios need to be highly diversified. Diversification, they might say, reduces the risk of one bad apple impacting the overall portfolio.
This viewpoint itself is not incorrect. The more diversified a portfolio becomes, the less likely it is that one significant underperformer will have an overall impact on returns. However, it also means that an outperformer will struggle to lift the overall value of the portfolio. In effect, diversification can become a double-edged sword.
How to diversify
So what's the correct answer? There isn't one. It all comes down to what an investor feels more comfortable with and what one wants to achieve.
Some investors might not feel comfortable having 50% or 60% of their assets in one investment. That's perfectly fine. The great thing about being an individual investor is there is never a requirement to buy a stock or fund. We can do whatever we want, whenever we want.
Rather than trying to figure out if it is better to have a diversified or concentrated portfolio, I think the question we should be asking is, what are we trying to achieve by having a diversified or concentrated portfolio?
What does diversification achieve?
Warren Buffett (Trades, Portfolio) has repeatedly said that he believes the best investment strategy for the average investor is to buy a low-cost, passive S&P 500 tracker fund.
Investors have taken his advice in huge numbers. Assets under management in passive funds have exploded during the past few decades. Robo advisors and investing apps have only helped investors build a portfolio of passive investments at the click of a button.
Investing in a fund that owns 500 different stocks appears to provide diversification, and it does, to a certain degree. However, due to the way the index is constructed, larger companies carry more weight. Apple Inc. (AAPL, Financial) and Microsoft Corp. (MSFT, Financial) currently make up nearly 11% of the index.
Based on these weights, the S&P 500 is essentially a ready-made portfolio with 11% of assets invested in the market's largest companies. As the S&P 500 is continually being rebalanced, it is a good asset for investors who don't have the time or inclination to analyze equities.
The challenge comes when investors try to pick stocks themselves. Without the automatic process of rebalancing, picking stocks to achieve diversification can lead to mistakes.
Seth Klarman (Trades, Portfolio) considered this topic in a lecture with students of the Ivey Business School just after the financial crisis. Klarman opined that many investors use diversification as a way to limit portfolio losses, but this strategy "presupposes that all your losses will be a one-off occurrence from a from a company having a particular problem, rather than the whole market going down."
He went on to add:
"So, we really don't think diversification provides the comfort people take from it. And we really think it limits your returns. If you can tell a bad idea from a good idea then how can you not tell a good idea from a great idea?"
Owning the market and owning individual stocks are different things altogether. If one tries to achieve diversification by holding a range of individual stocks, it's likely the portfolio will still experience a drawdown in a broad market decline. The diversification will not help.
At the same time, by splitting resources across equities, investors could reduce their profits when the market recovers. As Klarman's advice suggests, investors may be better off focusing on their best ideas.
This is why I believe the answer to the question of whether or not it is worth operating a diversified or concentrated portfolio of stocks depends on what one is trying to achieve. If one wants to avoid significant drawdowns, one might be better off avoiding stocks and focusing on other assets. If one wants to achieve high returns, a concentrated approach may be the best strategy.
