Is Diversification Really That Great?

by James on May 13, 2013 · 2 comments

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. Thus, your overall return increases.  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

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{ 2 comments… read them below or add one }

1 Jake Erickson May 14, 2013 at 10:15 am

Nice overview. Being that you’ve tried both methods, which one would you say is better for you? I’m currently going with the diversification (within common stock) route, but I’m not sold on sticking with this for the long-term future.

2 James May 14, 2013 at 7:00 pm

Jake,

It depends on how much risk you want to take.

Diversification should theoretically get you to superior return, but its unclear to me how much better the return is relative to the performance of the overall market. so, its safer.

That said, diversification won’t ever yield you returns of 100%, 200% or 300%. For these you need to focus your trading and investing efforts.

So, the bottom line is that it depends.

Best,

James

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