02 Aug Should You Diversify Your Stocks
There is this ongoing debate about the number of stocks to have in a portfolio.
Which number is the best?
When we are troubled by such decisions, we would refer to the words from people who we deemed to have authority.
And the first guy who comes to mind is none other than Warren Buffett, and he said
Diversification is protection against ignorance. It makes little sense if you know what you are doing
Ah ha! You must be thinking you are an investor who does all the due diligence and of course you are not ignorant. So you must not diversify. Just focus on a few stocks and wait for the money to roll in. Right?
Buffett went further with his analogy in baseball, and the same philosophy he holds with the player, Ted Williams.
As a batter in baseball, you want to hit the ball as far as you can. The pitcher on the other hand wants to throw you a curve ball that you couldn’t hit and strike you out.
Most batters will always swing the bat trying to hit the ball. Ted Williams has a distinctive style. He doesn’t swing on every pitch but only wait for the ball to be in the best zone for his swing. He was often criticised by this but he didn’t care and went on to be one of the best hitters in baseball history.
There were 28 players who have reached above .400 batting average and Ted Williams was the last player to have achieved it in 1941.
Buffett linked investing to Ted’s tactics,
What’s nice about investing is you don’t have to swing at pitches. You can watch pitches come in one inch above or one inch below your navel and you don’t have to swing. No umpire is going to call you out. You can wait for the pitch you want.
He understands the best investments are few and far in between. So it is important to choose wisely and end up with a concentrated portfolio. A diversified portfolio would have contained mediocre companies that would drag down the overall performance.
Isn’t that wise and logical?
I totally agree with the logic. But we have forgotten about an important assumption here: you are able to pick the really best investments in the world.
Let’s see what Buffett’s teacher, Benjamin Graham, had to say.
There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss-not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.
Hey, Graham isn’t wrong either right? It makes sense that no matter how careful we can be with our stock selection, we can still make mistake as we are fallible.
You can tell that Buffett is more of an optimist while Graham is rather, a pessimist.
So who is right?
Both can be right and wrong. It depends on what are the stocks you are investing in.
Buffett wants to buy the best and hence there can only be a handful. Graham’s style is to buy deeply discounted stocks which tended to be mediocre or might even have problems. Many people deemed Graham stocks as risky.
Graham had never deny the risk and mediocrity of these stocks but because they were so ridiculously cheap that an investor could make huge gains when things turn just a little better. Buffett achieved the highest percentage gains by investing in such stocks early in his career.
But Graham is not a seer and he does not know which stocks will go worthless, and which will recover, ex ante. Hence, his risk management strategy is to buy a group of them, so that the overall gains will be decent as the winners will more than compensate for the losers.
Conclusion: It is all about risk management
To answer the question, should you diversify your investments or not, it is a matter of what kind of stocks or financial assets you are putting into your portfolio.
The higher risk the asset, the more you need to diversify.
For example, I understand Christopher invests in high dividend yield stocks that generally come with higher risks. In this case he diversifies.
If you are engaging in crowdfunding, you should diversify too instead of putting a lot of money in one or two deals.
If you are investing in value stocks that are mediocre, you also need to diversify.
The only time that you do not diversify is that you are very certain you are very good at stock picking. And you can make a very sure bet it is going to be a big win. Then you should swing for the fences.
If you concentrate your bets and they are actually mediocre companies, you are in for a rude shock when you see how the returns unfold in the future.
Contrarian to what most people believe,you need to do more work if you have less stocks, because you cannot afford to be wrong.
Hence, diversification is not a preference. It is a matter of risk management.