When it comes to diversification, there are several schools of thought. There are those investors who believe that there is no need for diversification. A few core equity holdings are all one needs to achieve strong returns in the long-term. This is an approach that has been popularized by Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), although in recent years, Buffett has moved away from this style of investing.
On the other side of the table, there are the investors and fund managers such as Ray Dalio (Trades, Portfolio)'s Bridgewater. This firm has grown to become the world's largest hedge fund by running a globally diversified portfolio of assets and applying high levels of leverage.
The venture capital industry uses a similar approach. Venture capital managers tend to build vast portfolios of high-risk, high-reward bets in the hopes that one big payoff will make up for all the losers.
Both of these approaches have their merits and drawbacks. Some funds have made huge profits with a diversified portfolio. Others have struggled. Some have also made huge profits with a concentrated portfolio, but others have blown up by taking on too much risk.
For my part, I follow something between these two extremes. I am in agreement with Seth Klarman (Trades, Portfolio) that research and valuation are more important than diversification, but some diversification can also help mitigate the risk of putting all your eggs in one basket. This approach is a combination of a few core, well-researched bets, along with other well-researched but smaller positions.
Klarman's technique
In the late 1990s, Klarman described this approach in a letter to investors of his hedge fund, Baupost:
"A key component of our investment strategy is sufficient but not excessive diversification. Rather than own a little bit of everything, we have always tended to place our eggs in a few dozen baskets and watch them closely. These bargain-priced opportunities are selected one at a time, bottom-up, which provides a margin of safety in case of error, bad luck or disappointing business results."
Klarman went on to state that the fund was also trying to stay away from building too much exposure to one investment theme, which could lead to "dramatic and sudden reversals in our entire portfolio."
Some investors might dismiss the process out of hand because it is ultimately based on diversification, or as Klarman put it, "sufficient but not excessive diversification."
However, it is essential to note that at the core of this strategy is the need for detailed, rigorous research:
"Diversification is for us only the starting point for risk reduction. Solid fundamental research, emphasis on catalysts, value discipline, preference for tangible assets, hedged short selling, market put options and other strategies combine to create an overall portfolio safety net for our portfolio that we believe is second to none."
This point is often overlooked in the debate between sides in the diversification argument. Diversification or no diversification, what really matters is research. Whatever approach one takes, one must be willing to do the legwork to understand opportunities, how they work and their valuation. There is simply no alternative.
Arguably this is more important for a portfolio that has a high level of concentration, although it should not be overlooked in any situation. Valuation is also vital as it provides investors with a benchmark in uncertainty. As Klarman noted in another letter:
"In a stormy market, the value investing discipline becomes crucial, because it helps you find your bearings when reassuring landmarks are no longer visible. In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don't like their charts."
This feeds into the research requirement. Research builds an understanding of the business opportunity and provides a benchmark for investors to hold on to in uncertainty. It becomes a port in a storm and helps reinforce a positive investor psychology.
Put simply, diversification or no diversification, it is research and valuation that really matter in investing.
