Yahoo Finance To Diversify Or Not to Diversify?
Don't put all your eggs in one basket. Put all your eggs in one basket and watch that basket. Why should I invest in my 10th-best idea if I can invest in my first best?
These three statements are all contradictory ideas regarding the main tenant of investing: diversification. The first statement is the first thing you learn as a rookie investor: allocate your funds into different financial assets and construct a diversified portfolio. At business school, we teach students that diversification allows you to reach better risk-and-return trade-off. The omnipresence of this quote has made many take diversification as iron-clad law.
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The second statement is attributable to either Andrew Carnegie or Mark Twain (depending on the source you check). They could be right if and only if one can be sure that by watching the one basket around the clock you can guarantee it won't be toppled. Unfortunately in the investment world, this premise doesn't hold.
No matter how closely you watch your portfolio, prices will be subject to market swings that are out of your control. When Federal Reserve Chair Janet Yellen announces her belief about interest rates, she's rocking your basket and there's not much you can do about it. All your eggs will be affected. When Tesla Model S (ticker: TSLA) had a fatal crash, it's like one of your eggs is hit by lightning, and again, there's not much you can do to save it. Given that your eggs and your basket are vulnerable to unpredictable swings, it makes sense to put eggs into multiple baskets so that when some are hit, other baskets remain safe.
Then what about the third statement? This one is attributed to Warren Buffett, and he believes diversification is for ignorant investors who don't do their homework valuing stocks. For those who know what they are doing, investors should concentrate investments in their best ideas. A close look at Berkshire Hathaway's ( BRK/A, BRK/B) holdings reveals that Buffett follows this principle. Berkshire Hathaway has minority holdings of about 40 publicly traded companies. It may look diversified, but one needs to remember that these positions are acquired over a span of 50 years.
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What Buffett means is that diversification has a dark side. While it limits your loss at negative swings, it also reduces your gain at positive swings. Say, one of your baskets get showered by golden rain, had you put all your eggs into it, they would have all turned golden.
So what should novice investors do? Diversify or not diversify? Well, one has to trade off the loss of the upside with the protection on the downside. You need to ask yourself which is more important to you. For most people, the pain from losing money is felt more deeply than the joy in gaining the same amount on the upside, commonly called "loss aversion." If you are like that, then protecting your investment from the downside risk is a more urgent issue. The more loss-averse you are, the more you need to build a safety margin for your portfolio. And diversification is a powerful tool to build that safety margin.
How much you need to diversify also depends on your stock picking skills -- how capable are you in identifying undervalued stocks, which eventually determines the magnitude of the upside potential? The reason Buffett shies away from his 10th best idea is because he's confident in his top five. If you are still honing your stock-picking skills, which means you may have 15 mediocre ideas you are not sure about, then diversification may be for you. Because at this stage, limiting the number of stocks you invest in will harm you in both sides. It will risk you the safety margin while not rewarding you enough upside.
We all have limited time and energy. How many stocks do you have time to research on and make a sound judgment about its value? Probably not many. A well-diversified portfolio consist of at least 20 to 30 stocks across all market sectors. But is it practical for an individual investor who has a full-time job to pick and track 20-plus stocks? No.
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Five to 10 is already a lot to research on at a given time. The degree of diversification doesn't have to be static, though. When you start out, you can diversify more to protect your investment. But as you get better and better, you can concentrate more to maximize the upside potential of your portfolio.
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