Diversification is one of the main topics that splits opinion in the investment world.
On one hand, there are those investors who believe that diversification is not needed and as long as you are willing to do the research, you can run a relatively concentrated portfolio and still achieve impressive returns.
On the other hand, there is the group of investors who believe that diversification is a critical part of achieving investment success, and you are exposing yourself to unnecessary risk without a well-diversified portfolio.
Both sides of the argument have valid points, but it is notable that the world's greatest investors have arrived where they are today because they have used relatively concentrated portfolios. Only one or two few key bets have generated the vast majority of their investment returns over the past few decades.
Klarman and diversification
This topic of diversification is something I have been thinking about recently after watching a video Q&A session with Seth Klarman (Trades, Portfolio).
The session, conducted with students of the Ivey Business School just after the financial crisis, covered many topics, one of which was portfolio diversification and risk.
Klarman told his audience that the team at Baupost is "acutely focused on risk" and they believe that one of the biggest mistakes most investors is "over-diversification." The highly acclaimed value investor went on to say that investors make a huge mistake by owning 100 positions each accounting for just 1% of their overall portfolio, but are not willing to "identify the very best ideas."
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." If the whole market goes down, no matter how your portfolio is constructed, you're going to lose money. He concluded with the following statement:
"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?"
To diversify or not diversify?
Of course, when deciding on how concentrated your portfolio should be, at the end of the day it comes down to your own personal preference.
If you have the time to conduct rigorous due diligence on each investment opportunity before you take it, and are comfortable with the increased volatility that might come as a result of a more concentrated portfolio, then there is no reason why you should not use this approach.
On the other hand, if you think you may be spooked by your portfolio falling 20% or more in one day, then a diversified approach might be the better bet. If you are not comfortable running a concentrated portfolio, you could make some costly mistakes at a critical moment, which is something we all want to avoid making as investors.
However, as Seth Klarman (Trades, Portfolio) noted, using diversification as a shortcut is a strategy that is doomed to fail. If you think diversification will protect your portfolio against loss and think that, because you are diversified, you don't need to do detailed investment research, you could be in for a sudden shock.
Not a short cut
Diversification does not offer a shortcut to investment success. You might be more comfortable having a diversified portfolio, but the fact remains that research is probably the best tool investors can you use to limit losses. If you know what you are buying, you can be confident in your portfolio holdings and not need to water them down.
Disclosure: The author owns no share mentioned.
