Legendary investor Warren Buffett famously said,
“Diversification is protection against ignorance.
It makes very little sense for those who know what they’re doing.”
Warren Buffett
Let’s break this statement down and I’ll explain why I agree on the underlying premise but disagree on the wording used.
Ignorance is a strong word and implies a deficiency in investors. That is simply not true. Many great fund managers diversify their holdings depending on their world view and strategy. The world’s largest fund Bridgewater Associates is very diversified. It’s top holding is actually the SPDR S&P 500 ETF (SPY).
Many fund managers diversify equities among different sectors. Outside equities, funds also diversify with different asset classes. All this is done purposefully and backed with extensive research.
Rather, I would say that “diversification is protection against the unknown or black swan events”. Nobody knows what’s coming for sure, just like when the pandemic hit. Financial experts can tell you why assets move in certain directions after the fact, but none can predict the future accurately and with certainty.
The second half of Buffett’s statement makes more sense to me. For fund managers who spend all their working hours on research and building conviction, it doesn’t make sense for them to put money into many lower conviction stocks.
However, I would still prefer to rephrase it to “diversification makes little sense for those who have done their research, have high conviction, and have high risk tolerance”.
The important takeaway for retail investors like myself is that we neither have that much time or resources to spend on research nor may we even want to do so because it takes us away from our families and hobbies.
We need to be clear about our investment objectives. Are we in the stock market to make a quick buck but take on risk we may not be able to handle? Or do we want to build long term wealth sustainably with risk we are comfortable with?
From my experience, diversification offers 2 key benefits – time and peace of mind.
Time
Diversification can reduce the time required to research and manage our portfolios.
Personally, I invest to build wealth which in turn would allow me to spend less time on work and free up more time on life. I don’t want to be spending countless hours doing research on stocks because I have to, but rather because I want to.
How we diversify is important. Diversification by buying hundreds of different stocks in different sectors and geographies won’t help you save time. IMO the best way to diversify is through broad-market exchange-traded funds or ETFs.
For equities in particular, my core ETF holding is the Vanguard Total World Stock ETF (VT). VT holds the largest companies in the world! Doesn’t matter which country has the largest corporations or whether the US is still the largest economy 20 years from now. VT automatically takes care of all this for us. Rebalancing is done for us as company market caps (and stock price) go up or down.
No need to spend time to research, to keep up with results, to study financial statement, to buy and sell stocks, to look at stock charts.
More time to spend at the beach, to spend with your family, to spend on building passion projects, and to upgrade yourself to increase your income.
Peace of Mind
Diversification can help us mentally withstand short-term volatility and allow us to sleep soundly at night.
According to Modern Portfolio Theory (Harry Markowitz’s Nobel prize-winning work), assembling a portfolio of assets that behave differently to different market situations can lower risk without sacrificing too much in expected return.
In simple terms, if asset A goes up when asset B goes down, putting them together in a portfolio would reduce the overall magnitude of the shift.
The longer term effect on reducing risk through diversification is not so clear at least to me, but the benefits to managing short-term volatility is pretty obvious.
Investing is about playing the long game, unless you’re a short-term trader. For long term investors, it is more important to be able to ride out short-term volatility rather than to maximise return.
In addition, short-term volatility might also cause undue emotional stress for those who are underprepared or overexposed.
Even if you picked a multi-bagger stock but ended up selling during tough times, you might have lost out on the opportunity to gain outsized returns.
It pays to be patient but it also helps psychological when your portfolio isn’t dropping as much during a market crash, unless you have nerves of steel.
Getting Started
Head knowledge is one thing but you will never really know how you actually react until you have experienced fear uncertainty and doubt (FUD) in a market crash, bear market, or at least a market correction.
If you’re just starting out, you’ve probably not gone through one before and you’re unsure how you’d react. The recent tech and growth sell-off in February was a good example.
Not financial advice, but newer investors might be better off starting with a diversified portfolio, preferably with low-cost, broad-market ETFs. You won’t be getting crazy returns but you would also be reducing your chances of experiencing huge drawdowns.
As you understand how your portfolio, and more importantly how your emotions and psychology responds to market drawdowns, you can refine your portfolio and possibly start concentrating to your higher conviction names safely.
But until then, start small, be patient, and learn as much as you can about your emotions and psychology. A great investor is one that is calm, measured, and sleeps like a baby even when there’s a stock market meltdown and everyone calling a doomsday scenario. Wish you all the best and hope you get to that point soon.
I’d love to hear from you. Is your portfolio diversified or concentrated? And how long have you been investing? Let me know in the comments.
Disclaimer: This is not financial advice. I am not professional financial advisor nor do I work in the finance industry. Anything I write here is purely my personal opinion. Please do your own research and due diligence before investing into anything. All investments come with associated risks. Best to consult a financial advisor if you’re still unsure.