Diversification in Your Portfolio: “You call that a position?”

“[Soros taught me] it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – Stanley Druckenmiller.

The conventional wisdom a typical investment advisor will say, “Diversify your risks. Your portfolio should be divided among equities, bonds and cash.”

However, what irks me the most is when it is mentioned that to have higher return equates to taking on higher risks. Equities carry higher risk than bonds. Therefore, it is important to diversify your portfolio among the various investments of the various risk levels. This logic cannot be more flawed; diversification for its own sake is not at all sensible.

As an investor, my key tasks are capital allocation based on the expectancy of your return on invested capital and more importantly, risk reduction.

The best investors such as Warren Buffett are terrific risk managers. To George Soros, success in investment comes from “preservation of capital and home runs.”

Diversification may minimize risk, but at the same time, it can have an adverse side effect on profit potential. Having too many holdings can assure that even a spectacular gain in one holding will have a diluted effect on your portfolio value.

Concentration in a small number of investments will make a difference. Concentration results from the way an investor approaches and selects his investments. In this way, opportunity cost is considered. After all, the top 5 stock ideas are likely to generate a higher returns than the 50th stock idea on the list. Therefore, when you have tremendous conviction on a trade and when the opportunity presents itself, make sure you go for it to make a real difference to your wealth.

However, there are no guarantees, and even the best investors makes mistakes. But the idea is to approach diversification based on your assessments on the risks they entail and the expectancy of your return on invested capital rather than allocating capital in many different investments you own for the sake of it.

“Diversification is a protection against ignorance. [It] makes very little sense for those who know what they’re doing.” – Warren Buffett

Think about this for a moment:

Compare two portfolios. The first portfolio is diversified among 100 different stocks; the second portfolio is much more concentrated, with just 10 stocks.

Now if one of the stocks in the first portfolio doubles in price, the portfolio value rises just 1%. However, the same stock in the second portfolio will cause the portfolio value to rise 10%.

Now what you think is easier to do?

– identify one stock that is likely to double in price;

– identify 20 stocks that are likely to double?

An investor that knows a lot about a few investment holdings will be better off than knowing only a little about a long list of holdings.

The reality is that when you look at those who achieve the greatest wealth, almost none of them ever diversify, or at least throughout most of their years. Imagine if Bill Gates, Mark Zuckerberg, or Jeff Bezos diversifying into the S&P 500 after their companies’ IPO, they’d probably have a fraction of the wealth they do today.

“I can’t be involved in 50 or 75 things. That’s a Noah’s ark way of investing – you end up with a zoo that way. I like to put meaningful amounts of money in a few things.” – Warren Buffett

 

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