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Oliver Hauschke
Oliver Hauschke
Articles (3)  | Author's Website |

Is Diversification the Opposite of Risk Reduction?

'Diversification is the most important component regarding risk reduction.' Most investment professionals would agree to this statement and private investors believe it. But is this statement true?

February 05, 2018 | About:

One of the first things you hear when starting your investment career is that you have to diversify your investments. Your bank manager is saying it. Your friends are saying it. You can read it everywhere.

If you want to reduce the risk of losing your hard-earned money on the financial markets, you have to spread your investments among various financial instruments, industries, regions and so on. The idea of diversification is that each investment area reacts differently to the same event. That may lead to a loss with one investment, but to a win with another. In the end, you will get decent returns.

Does this sounds logical to you?

Yes? It does to many other investors too. That's why ETFs are so popular among small private investors. When I sneak through different forums on Facebook and someone asks what he should invest in, the answer most of the time is the MSCI World Index, mainly because of its broad diversification.

But what if I say to you that diversification is the opposite of risk reduction? Wouldn't you say I'm crazy?

Maybe you're right, but let's think it through!

As I mentioned above, the concept of diversification implies that you buy many different financial instruments, industries and so on. You can't invest in everything, so if you're not willing to invest in an ETF, you have to decide what instrument you would like to invest in. You have to decide in which industry (all?) and regions you should invest and how you allocate your money. This is really a difficult task and could be risky.

Why?

Because if you really want to be successful, your decision should be based on your knowledge about your investments. It is a challenging task for an average private investor to know everything needed for making a reasonable decision on all the investment opportunities. And I guess the fewest do know enough.

But if you don't know enough about them, the decision is based on assumption. And assuming is a risky game. It's like a bet on the correctness of your decision. That's why Benjamin Graham has said that the investor's chief problem is "likely to be himself."

Many will argue that it is one of the tasks of diversification to deal with the unsuspecting nature of the average investor. But this is not dealing with it. This is bringing risks into your investments: the risk of not knowing and the risk of choosing too many bad investments and hoping at the same time to have enough good ones that compensate for the losses of the bad ones.

Many average private investors know too little about their investments. What is really scary is that many are satisfied with it. They decide that just because the company is popular or the stock has risen over a period of time that it will go on. They decide based on the necessity of diversification to buy more or less arbitrarily.

Too much diversification is more an expression of not knowing, fear and distrust in one's own investment decisions. Investors who spread their portfolios widely assume that they are making poor selections. So they expect losses. Not short-term losses, because of the market volatility, but long-term losses, because of choosing bad companies.

That's why Warren Buffett (Trades, Portfolio) said, "Diversification is a protection against ignorance. It makes little sense if you know what you are doing.“ In this sense, diversification protects against the investor, not against the investment.

But what about the investments? Is diversification also a protection against bad investments, thereby reducing the risk of losing money?

Well, as a value investor, you're searching for outstanding companies at a fair price or better companies at a bargain. A value investor buys within his circle of competence and with a reasonable margin of safety. Both are elements of risk management. Diversification ignores both of them. Therefore, it is more the opposite of risk reduction.

Let's make that concrete

The more companies you own, the less you could know about each of them, which increases the risk of making a wrong decision. Besides, an investor won't find an unlimited number of outstanding companies. That's why diversification implies the investment in mediocre or bad companies and therefore increases the risk of loss.

Warren Buffett is of the opinion that concentration in a portfolio reduces risk because less diversification leads to thinking about one's investments more intensely and leads to better decisions.

Does this mean that you should focus on just a few investments, maybe a single share?

Of course not. But it means one should not exaggerate diversification. Both too little and too much diversification increases risk. The investor has to be aware of this. The winner finds the right way between. He decides on the basis of his knowledge and he buys quality rather than quantity at a reasonable price.

About the author:

Oliver Hauschke
Oliver is a private Value Investor for over 25 years.
He is also founder & CEO of the Bridge2Fortune® Academy where he combines his passion for investing and education to help people learn about value investing.

Visit Oliver Hauschke's Website


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