Is Diversification Really That Great?
Like many of you, my web surfing has taken me to many corners of the personal finance blog world. As I've been surfing, I've noticed that sometimes there is a bit of tension between the relative merits of diversification and focused investing. Having tried both styles, I thought I'd share my thoughts with you.
On Diversification
The main objective of diversification is to manage risk and maximize return. Much of the philosophy of diversification is based on a 1952 article by Harry Markowitz entitled "Portfolio Selection". Markowitz's main thesis by now has become common knowledge: if you diversify your portfolio of common stocks, you limit your exposure to the risks of underperformance of any one specific stock. An extrapolation of Markowitz's theory is that each particular investor has a specific efficiency frontier or point at which their portfolio is producing maximum returns for a given level of risk.
In the real world, people usually cite modern portfolio theory as a rationale for choosing to invest in mutual funds. The basic argument here is that mutual funds provide diversification and professional management that most individual investors cannot adequately achieve on their own.
Click here for more about modern portfolio theory (MPT).
On Focused Investing
All this talk about diversification has a flip side. I've read several interviews with serious investors, (serious, like Warren Buffet serious), who have given me some perspective on the issue. Basically, the counter argument for the diversification theory is that while it makes a great deal of theoretical sense, in the real world taking a focused position in a particular asset (common stock issue, real estate, etc.) can be the best way to maximize your return. This partly what Warren means when he says "Wide diversification is only required when investors do not understand what they are doing".
Its been my experience that I've been able to make most of my money through focused investing. For example, when I sold my first condo, I put nearly all of the money into a small apartment building. Miel and I later sold that building and invested the bulk of the money in the Hansens Natural Corporation. The main point here is that much of what we have is due to relative focus, not diversification.
Best,
-James
Stumble It!
2 comments:
Hi James:
Bill Bernstein provides the most concise argument for diversifying a portfolio. Simply stated, a focused approach gives one the best chance of striking it rich, but it also gives one the best chance of ending up in the poorhouse. See The 15-Stock Diversification Myth for the proof,
regards,
Barry
There are too many variables here to consider whether either is a good option. It totally depends on the investor and their investing needs.
For one investor diversification will be the answer while for another focused investing will be what they're looking for.
Diversification gives a more secure and balanced approach to investing. Focused investing, as Barry points out, can provide extreme results either way, but if you have the desire, willingness and time to succeed at it then this is a great investment model.
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