Is Diversification Helping or Hurting Your Investments?

Diversification is a term that every investor has heard of, and it’s a concept that many people use when designing their portfolios or planning for the future. However, some of the greatest value investors of all time actually shun the idea of diversification. I guess the question we want answered is why do these investing professionals look down on diversification while we have been taught that it is a good thing?

What is Diversification?

The basic goal behind diversification is that you mitigate your risk by investing into multiple different assets at once. This comes in many forms, such as asset class diversification, industry/sector diversification, and geographic diversification. Each of these strategies seeks the same outcome: to protect your investments from volatility and to get rid of unsystematic risk.

Diversification plays on the law of averages, which says that natural or random events will eventually balance out over time. Some of your investments may be big hits, while others depreciate in value. When you diversify you are accepting an average return and giving up certain explosive growth potentials as well as detrimental underperformers.

The Basics

When you begin to learn the basics of investing, people are usually taught that diversification is a good thing. Design your portfolio in a way that protects your money from market hazards. In fact, one of the most popular securities in the world works wonders through diversification. 

The S&P 500 index fund is one of the greatest developments in investing history, diversifying an investor’s initial principal into the 500 largest publicly traded companies in the United States. Since its creation in 1957, it has produced ~10.5% average annual returns. To put this into perspective, less than 1 in 10 investors are able to beat the returns of the S&P 500 in the long run, making it possible for almost anybody to benefit from the growth of the stock market with little to no research.

So investing is solved, right? Not necessarily. For the average person, diversifying through funds is going to be the easiest and best option for long term success. This is why the backbone to American retirement plans often involves index and mutual funds that are left alone to compound over time. But professional and retail investors don’t always settle for this (though, many of them may have wished they had).

Beyond the Basics

If diversification is so great, then why do we have role model investors telling us to avoid it? Peter Lynch, a legendary fund manager known for his ability to identify small, fast growing companies, calls it di-worse-ification. Not only does he hate it when his companies over-diversify, but he fights against the need for amateurs to do so. Warren Buffett, arguably the greatest investor ever, says that diversification is only protection against ignorance, and he has no use for it.

Lynch’s argument against diversification is that it pushes people outside of their circle of competence. Lynch believes that researching one stock is hard enough, and avoiding complacency is important. The average investor doesn’t have time to check on the 30 different stocks they own by digging through every quarterly report, so they are bound to miss things (and get complacent).

Additionally, Lynch points out that if you truly find a stock that you believe in, then why should you invest in other companies that seem less promising? In other words, he sees nothing wrong with “selling the farm” for the big bet. Buffett approaches the issue similarly. Knowing that he has a unique talent for finding great businesses, he isn’t forcing himself to diversify from his winners (especially since they can be very hard to find).

Find Out What You Want

Diversifying your investments isn’t inherently bad, but you should define your goal. Value investors hoping to maximize their profits can put diversification on the back burner if they are truly invested into their strategy. However, many people want their money to combat inflation, deliver compounding returns in the future, and potentially create additional streams of income. Whatever you decide, make sure that your investment strategy is tailored to the outcome.

• Value Investing – this strategy requires investors to engage with their investments through research and evaluation. Value investors seek to find underappreciated businesses and buy them at prices below their intrinsic value. This is the kind of approach that doesn’t benefit from diversification. To learn more about value investing, check out my guide to researching individual stocks: How to Research Stocks.
• Passive Investing – this strategy involves consistent investments into a diversified portfolio or fund which seeks to benefit from compounding interest (see why this is so important here). Passive investing usually includes dollar-cost averaging to stream line the consistent returns even further. The good part about this is that it requires little to no effort on the speculative front. It is the easiest way to take advantage of the growth within the stock market.

Beyond these strategies there are further diversifications to be made outside of the stock market, including bonds, precious metals, real estate, and digital assets. Once you’ve decided on your goal and how much effort you are going to put forward achieving it, then you can answer the question “is diversification helping or hurting me?”

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