When newcomers start to invest, one of the first lessons they come across is a lesson on diversification. Just about every article with tips on reaching investing success talks about diversification.
On the other hand, some of the world’s most well-known investors advise against a diversified portfolio. Even the great Warren Buffett was famously quoted as saying, “Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.”
Proper diversification is one of the hardest parts of investing. The truth is that there’s no exact science to it. There’s no real right or wrong way to invest or to diversify. By its very nature, investing is the process of accurately attempting to predict the future. It’s figurative fortune telling.
Since there’s no way to accurately predict the future 100% of the time, there’s no exact roadmap to investing success. In fact, it’s this conundrum that brings the term diversification into play.
The idea is simple: Since no one can tell the future, every investor will make the wrong move at some point. A diversified portfolio ensures that when that wrong move is made, all is not lost.
So, who’s right? Buffet and George Soros, who say that diversification is for chumps, or thousands of investment professionals who preach diversification as one of the key elements of a healthy investment portfolio?
They’re both right, and they’re both wrong. It just depends on who’s doing the investing.
What Is Diversification?
The idea with diversification is to spread your investment dollars across a wide range of financial instruments, industries, and assets. That way, if the value of a single investment suddenly sees dramatic declines, the entire portfolio doesn’t suffer.
Diversification happens on several levels.
Diversification of Investments Within an Industry
This type of diversification only provides protection against the sudden decline of a specific stock. For example, if you’re a tech investor, instead of simply investing in Apple or Amazon, you would invest in a wide range of technology companies. If Apple were to suddenly not be able to sell an iPhone, the stock would tank. If you only invested in Apple, you would experience substantial losses. On the other hand, if your investment funds are spread across a wide range of technology stocks, gains in other stocks would offset the losses you experience in your Apple shares.
The idea behind industry diversification is to protect yourself against declines that affect an entire industry or sector of the economy. By investing in other, unrelated industries, you can offset industry-wide declines within your portfolio.
Think about the dot-com bubble. During the bubble, investors were fixated on the technology sector. Anything with “dot com” in its name generated investor interest. But like all market bubbles, the dot-com bubble eventually popped. When that happened, the tech sector as a whole felt tremendous pain.
If you only invest in technology, and this type of event happens again, you would be subject to significant losses. On the other hand, if you spread your money out across the technology, oil and energy, health care, consumer goods, and industrial sectors, the gains from sectors outside of the technology sector would help to shield your portfolio from overwhelming losses.
Diversification Across Asset Classes
This type of diversification helps protect investors against the collapse of an asset class as a whole. For example, just take a look at the history of the stock market. Throughout the years, there have been devastating stock market collapses, most of which have been heavily correlated with economic conditions.
When economic hardship hits, investment interest tends to fly out the door, leading to incredible declines across the stock market. During these times, if your portfolio consists only of stocks, you can expect to experience a high level of losses.
To protect against these losses, investors invest in multiple asset classes. For example, they may include gold and silver in their investment portfolios to offset stock losses. These are known as safe-haven investments, or investments that trend upward when economic and market conditions are poor.
What’s Wrong With a Diversified Investment Portfolio?
If so much protection is offered through diversification, why is it that some of history’s most successful investors are so against it? As much as diversification may protect your portfolio from extreme losses, it can also hinder your portfolio from experiencing tremendous gains.
You’ll often hear people say things like, “If you invested $10,000 in Amazon in 2006, you would have more than $650,000 today.” There’s no denying that fact. Amazon’s stock is trading at more than 66 times the price it was trading at back in 2006. Making a large investment back then would have proven to be an incredibly fruitful move.
There’s only one problem, and it’s a big one. According to the CNBC blog Make It, the average American has under $9,000 in savings at any given time. So for the average American, making a $10,000 investment in any stock leaves no room for diversification.
Let’s say an investor has a lightly diversified portfolio with 10 different investments of equal value. If that investor invested $1,000 in Amazon in 2006, the value today would be over $65,000. That’s not a bad chunk of change, but it’s not a life-changing amount of money either. Moreover, some of these gains may have been eaten up by declines in any of the nine other assets over that time. After all, isn’t that the point of diversification?
In this case, diversification worked against the investor. Today, that investor could have had more than $650,000, but their portfolio is likely far short of that figure due to light diversification. Diversifying further would mean that the investor would have had even less exposure to Amazon, leading to even fewer gains experienced from this stock’s spectacular run.
The Point Warren Buffett Is Trying to Make
There’s a lot we can get from Buffet’s statement. First and foremost, diversification is essentially a form of insurance. While it provides protection from tremendous declines, it can also be quite costly when specific stocks make incredible runs.
It’s a great comparison too. Think about it from the standpoint of homeowners insurance. According to the Insurance Information Institute, in 2017, about 6% of insured homes had claims on their plans. As such, around 94% of people who paid for homeowners insurance did not use it, accepting a loss on their investment in the service.
Looking at insurance from this perspective may not make a lot of sense; it seems as though home insurance is viewed as a necessity by the average American. Essentially, consumers pay a premium for little more than the feeling of security.
In his famous quote, Buffet likens diversification to insurance. Investors are simply insuring against inadequate research in this case, rather than against a hoodlum breaking a window or stealing a piece of jewelry. Nonetheless, that insurance comes with a cost, as all insurance does.
The second part of Buffett’s famous quote — “It makes very little sense for those who know what they are doing” — is just as important. The idea is that there’s no reason for the protection offered by diversification when the investor takes the time to research and understand their investment decisions.
For example, an investor doing research in 2006 could easily have found a trend taking place. Consumers were shopping more online than ever before. Each year, more and more online sales were happening as the world’s preferences in shopping started to change.
At the same time, Amazon was starting to emerge as a leader of the industry. Taking note of the fact that consumer habits were changing and online shopping was growing, it would have been a great decision to look for strong investments in the online retail space. Considering that Amazon was starting to lead the charge, it would have been an obvious choice for an investment in the space.
With enough research, an investor would have seen a potentially lucrative long-term investment opportunity, and making a large investment in the stock would have paid off in tens of multiples. There’s a strong chance that several opportunities like this are taking place as we speak, under the radar of many investors today.
So, by taking the time to do the research and understanding what you’re getting into, you can escape the need to diversify, as far as Buffett and other investing gurus are considered.
So, Which is Right? Should You Diversify or Not?
Every investor has unique goals, abilities, appetites for risks, and more. There is no one-size-fits-all answer to this question. Nonetheless, there are three questions you can ask yourself to see whether diversifying is best for you:
- Are You a Beginner? In his statement, Buffet said that diversification makes little sense if you know what you’re doing. However, there’s no shame in being a beginner and — for lack of a better way to say it — not knowing what you’re doing. If you’re a beginner, it’s best to heavily diversify your portfolio while you learn the ropes. Only expert investors know the market and how to analyze a stock enough to forego diversification — and even they sometimes get it wrong.
- Do You Have a Strong Appetite for Risk? Even as an expert, you may not be comfortable taking on the risk of putting all your eggs in one proverbial basket. With diversification being a matter of protection, failing to do so expands your risk of loss. If you don’t have a strong appetite for risk, you may want to diversify regardless of your understanding of the market.
- Do You Have a Keen Ability to Research? Without diversification, you’re making a big bet that the decisions you make in the market are correct. While there’s no way to tell the future, proper analysis and research will greatly expand your chances of being correct in your investing decisions. However, if you don’t have a keen ability or inclination to deeply research investment opportunities, diversification is the way to go.
Ultimately, there are a select few people who can get away with little to no diversification in their investment portfolios. While it would be great to have all of your money in that one stock that flies up dramatically over time, it can also be painful to get caught in an Enron-type scandal and lose it all.
Diversification is a hot topic that is not met with much debate. Although some of the greatest minds in investing avoid diversifying, it remains important especially for the beginner investor.
Sure, diversification may water down dramatic gains you may experience over a period of time if you’ve chosen a great investment. However, picking that stock that’s going to see those dramatic gains is like finding a needle in a haystack.
It’s easy to look back and say, “I should have put all of my money in Amazon back in 2006.” The problem is that in 2006, with the information available at the time, it would have been hard to trust all of your money to that one company, and nearly impossible to predict that it would grow to become one of the largest companies in the world.
The bottom line is that hindsight is 20/20. As easy as it may be to say, “I shouldn’t have diversified,” making the decision to avoid diversification is difficult, and in many cases can be quite costly. Getting rich in the stock market is the result of compounding gains over time. Diversification helps to protect those gains as they work for you.
How do you diversify your portfolio? How does your diversification strategy fall in line with your appetite for risk?