Decoding Diversification
A Deep Dive into the Benefits and Drawbacks of Spreading Your Investments
Today, we’re diving into one of the most universally accepted concepts in the world of investing: diversification. For those of you who’ve followed our posts, you know we’re not afraid to question established dogmas. We explore whether certain strategies are as essential as they’re often made out to be, or if sometimes it's better to swim against the current.
Diversification is often touted as an absolute must in the investing world, especially for beginners, and for good reason—there are many valuable insights around it that are crucial to understand. However, some of the claims about what diversification can achieve might warrant a closer look. In this post, we aim to help you steer clear of the myths and misconceptions around diversification. Thank us later—but first, read through the entire article!
Does Safety Really Lie in Numbers?
Conventional wisdom often champions diversification as a cornerstone of successful, long-term investing. The advice goes that by spreading your investments across a range of stocks, sectors, or even asset classes, you can protect yourself from undue risk. Diversification is indeed a well-established strategy for managing risk by allocating investments across different types of assets, industries, and geographic areas. However, as with most popular investment principles, the concept of diversification has nuances and limitations that aren’t always fully considered or discussed.
First, let’s briefly revisit the reasoning behind diversification, as we assume most readers are already familiar with the basic concept.
The core idea of diversification is risk management through broad exposure. By distributing your investments across different companies, sectors, and regions, you reduce the likelihood that any single event could drastically impact your entire portfolio. Diversification helps shield you from the risk associated with individual companies, which can face unexpected downturns or even failure—sometimes due to their own missteps, sometimes purely due to misfortune. Such company-specific events are notoriously hard to predict, particularly for outside investors. By spreading investments, one can minimize these unique, or idiosyncratic, risks that are specific to individual companies.
Two other common risks addressed through diversification are geographic and sector risk. Any seasoned investor has likely heard that spreading their investments across different countries and sectors can help avoid the potential fallout from issues confined to one particular region or industry. A sector downturn or an economic crisis in one country, for instance, will not necessarily have a ruinous effect on a diversified portfolio, especially if exposure is balanced with investments in other areas.
However, diversification cannot protect against all types of risk—a point even the most enthusiastic proponents of diversification will acknowledge. Broad, market-wide challenges, known as systemic risks, still pose a threat. While a failed product launch from a single company would likely have a minor effect on a diversified portfolio, the consequences of a global economic downturn could be much harder to escape, as such recessions tend to impact companies across the board.
Yet, even with systemic risks, diversification continues to offer benefits by spreading out portfolio exposure. Unless all companies are affected equally by a downturn, diversification helps buffer the total portfolio impact, since not all companies will react identically to economic headwinds. In this way, diversification may not eliminate every risk, but it remains an essential tool for managing overall portfolio volatility.
This all sounds great, and you might be wondering why we’re choosing to scrutinize the concept of diversification. Well, our interest in re-examining this principle was sparked by a significant group of investors who actually stand opposed to diversification. And leading that call is none other than Warren Buffett himself…
Buffett’s Take: Diversification Weakens Returns
“Diversification is a protection against ignorance,[It] makes very little sense for those who know what they’re doing”
Warren Buffet
It might seem surprising that one of the most universally accepted principles in investing—diversification—is so sharply criticized by none other than Warren Buffett, often regarded as the godfather of investing. And he’s not alone in his stance. Many voices argue against diversification, citing its dampening effect on returns. The reasoning goes that your 20th best idea will likely deliver lower returns than your very best idea. There’s a certain logic to this: a portfolio of 20 top stocks will, in theory, yield lower returns than a more concentrated portfolio of only the five best-performing stocks.
There are further arguments against diversification as well. Bernard Baruch, a highly successful financier and economic advisor to several U.S. presidents, argued that it’s unwise to spread investments across too many different securities. Keeping up with all the factors that could impact a stock’s value takes time and focus. It’s possible to know everything about a few select investments, but it’s virtually impossible to stay fully informed about a large number of them. Managing a portfolio of 50 companies makes it challenging to stay updated on each one, which could prevent timely responses to changes in any given company’s situation.
Another argument is that some sectors and companies tend to be more volatile or less profitable than others. Spreading investments across all sectors just for the sake of diversification can lead to exposure in less desirable or riskier parts of the market, potentially reducing the overall appeal of the portfolio.
This perspective questions whether broad diversification truly serves investors seeking optimal returns, suggesting instead that a concentrated approach with carefully chosen investments may yield greater rewards.
As we weigh these points, it becomes clear that diversification isn’t the open-and-shut case it’s often made out to be. Could it be that the time-honored diversification mantra has its flaws?
Making Sense of Diversification
To answer the question: yes, diversification has its flaws. However, we would still recommend it to 99% of investors. Why? Because achieving outperformance with a concentrated portfolio requires an exceptional level of skill—or a stroke of extraordinary luck. Only investors like Warren Buffett have the expertise to consistently identify great investments (think: top-tier companies at attractive valuations). So Buffett’s advice on diversification can be interpreted like this: you diversify because you’re not fully confident in your ability to always be right about the companies you evaluate and value. In other words, diversification is a way to protect yourself from your own limitations.
And this is actually a smart strategy. Research shows that investors often overestimate their abilities. We, too, believe that most investors (ourselves included) aren’t equipped to consistently generate strong results with a concentrated portfolio. Aswath Damodaran, known as the "Godfather of Valuation," highlights two key factors that should influence the degree to which you diversify.
If you invest in equities, Damodaran argues, diversification becomes essential for two main reasons. First, it’s nearly impossible to determine the exact value of an equity investment with complete confidence, as expected cash flows are only estimates, and risk adjustments are not always exact.
Second, even if your valuation is accurate, there is no specific deadline by which the stock price must align with its estimated value. Unlike bonds with set maturity dates or options with expiration dates, stocks can remain undervalued or overvalued for extended periods—and may even become more mispriced over time.
Final Thoughts
We believe it’s fair to conclude that diversification is a solid strategy to reduce the risk of permanent capital loss. By ‘placing your bets on multiple horses,’ you protect yourself not only from your own limitations but also from the potential missteps of company management and unforeseen events that could impact a particular region, company, or sector.
That said, diversification should never be pursued just for its own sake. If you spread your investments too thin, you’ll inevitably dilute your returns. There is such a thing as too much diversification. Since we’re convinced that many investors diversify without being fully aware of the downsides, we’ve decided to write a practical (and brief) guide on how we approach portfolio diversification and how you can optimize yours. If you’re interested, be sure to subscribe so we can keep you updated!
Please note: This article includes a disclaimer regarding investment advice.