Diversification is an extremely important aspect of investing. It means that an investor is not reliant on the performance of a small number of stocks to generate returns. Similarly, it means the overall value of their portfolio will be less affected by a decline in the share prices of holdings.
However, diversification can also present difficulties for investors. For example, an investor may only be able to identify a small number of significant buying opportunities over a given time period. As a result, they may end up buying companies they do not believe offer a significant mispricing opportunity because they are seeking to ensure their portfolio is diversified.
In fact, it could be argued that diversification will inevitably lead to worse long-term returns. An investor’s best idea, in terms of which stock to buy first, is likely to be superior to their second-best idea, and so on. As such, while diversification is necessary to limit risk, there is the potential for it to be detrimental to portfolio returns.
Munger’s strategy
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Vice Chairman Charlie Munger (Trades, Portfolio) has previously discussed his reliance on a relatively small number of ideas that have together delivered high returns. As he once said, “If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor.”
Munger’s words are extremely relevant to all investors. He is widely regarded as one of the most successful investors of all time, yet even he has only been able to identify an extremely small number of worthwhile buying opportunities throughout his career. Therefore, it seems perverse to think other investors will be any different in terms of being able to identify a sufficiently wide range of ideas that provide an ample level of portfolio diversification.
A balanced approach
Of course, investors who only purchase a small number of stocks over the long run will inevitably end up with a concentrated portfolio that lacks diversification. This could lead to high returns. Equally, though, it is likely to be a high-risk strategy that may not be suitable for the majority of long-term investors.
Therefore, in my view, investors must seek to strike a balance between limiting risk via diversification and maximizing returns by only investing in their best ideas. Clearly, this will be linked to their level of risk tolerance. For instance, investors willing to take on more risk will naturally seek to diversify to a lesser extent. Moreover, it is likely to be highly subjective in terms of what constitutes a diverse portfolio. Different investors will have their own views on this.
However, the idea of expecting a well-diversified portfolio to offer significant stock market outperformance may be misplaced. Greater diversification may lead to less appealing stocks being held. Ultimately, this may detract from returns over the long run. The extent to which this is viewed as being beneficial, in terms of the risk reduction diversification brings, is a decision all investors may be required to make.
