I’ve had some lively debates in the past several days on the issue of diversification. The conventional wisdom is that a portfolio should be diversified to limit the risk of any one position blowing up and destroying returns. Diversification is supposed to “smooth” returns and protect one’s downside. But there’s a catch — the more diversified a portfolio, the more it tends to match the market’s return.
Those espousing conventional wisdom would surely balk after taking a look at my portfolio. I own only three stocks, one of which comprises around 50% of the total assets. Plenty of advisers, academics, etc. would probably think I’m nuts, but I’d like to make a case for a different paradigm of risk and reward. I believe that the determining factor in how much one should diversify turns on how much one understands about the stocks in which they are invested. Graphically, this might look something like:
The reason for this is simple. If one understands and properly evaluates the risks of one’s “best” holdings, they incur opportunity costs by allocating capital to more and more investments. This drags down returns and dilutes the investors’ capacity for understanding any particular investment.
Yes, a focused portfolio will increase the standard deviation of returns, but for long-term investors, this should be of no concern. Risk comes in doing something one does not understand more than from fluctuations in price.
None of this is to say that it’s always a bad idea to diversify. Quite to the contrary, for investors who either do not have the time or skillset to evaluate an individual stock, diversifying is probably a good idea. In fact, I’d recommend index funds (extreme diversification) for the average investor who has neither time nor desire to research investments.
But for those who do wish to pick stocks, as it were, the most important thing they can do is to clearly define a circle of competence — that is, to determine what they understand fully and to stay within that circle. And it’s important to note that it’s not so much the size that matters but how well one defines the outer limits. You don’t have to know many things well or do many things right to beat the market.
Those espousing conventional wisdom would surely balk after taking a look at my portfolio. I own only three stocks, one of which comprises around 50% of the total assets. Plenty of advisers, academics, etc. would probably think I’m nuts, but I’d like to make a case for a different paradigm of risk and reward. I believe that the determining factor in how much one should diversify turns on how much one understands about the stocks in which they are invested. Graphically, this might look something like:
The reason for this is simple. If one understands and properly evaluates the risks of one’s “best” holdings, they incur opportunity costs by allocating capital to more and more investments. This drags down returns and dilutes the investors’ capacity for understanding any particular investment.
Yes, a focused portfolio will increase the standard deviation of returns, but for long-term investors, this should be of no concern. Risk comes in doing something one does not understand more than from fluctuations in price.
None of this is to say that it’s always a bad idea to diversify. Quite to the contrary, for investors who either do not have the time or skillset to evaluate an individual stock, diversifying is probably a good idea. In fact, I’d recommend index funds (extreme diversification) for the average investor who has neither time nor desire to research investments.
But for those who do wish to pick stocks, as it were, the most important thing they can do is to clearly define a circle of competence — that is, to determine what they understand fully and to stay within that circle. And it’s important to note that it’s not so much the size that matters but how well one defines the outer limits. You don’t have to know many things well or do many things right to beat the market.
