Should You Concentrate Or Diversify Your Investments?
Investing can be a time-consuming and tedious activity. We as investors need to have sufficient time on our hands for analysis, the required psychological fortitude to withstand occasional market shocks, as well as the financial resources to continue to purchase shares of good companies and compound our dividends over time.
Given that we all have a finite amount of time, should we diversify more, or concentrate we investments? Let us look into the pros and cons of each method.
The ignorant investor
Warren Buffett, the famous value investor, famously quipped that “diversification is for ignorant investors.” While this may sound offensive, let’s break down what Buffett’s statement means.
Ignorant investors are defined as those who may not have the capability or aptitude to read and interpret financial statements. Hence, such investors may suffer big losses when they try to pick stocks with their limited knowledge. Looking at it from this context, diversification protects such investors as they would own a large basket of stocks, such that if any single stock does poorly, it will not make a significant dent to the overall portfolio performance. Buffett was trying to protect investors by making that comment, and it seems he was justified in doing so.
The pros and cons of diversification
Diversification also means that we would not need to spend much time on analyses and reading when we may be busy with other aspects of life. It allows us to sleep soundly and provides peace of mind.
The downside to diversification is that we cannot hope to do better than the average performance of the stock market, as our portfolios would track the overall returns of the benchmark index. A performance which is better than the market is termed as “alpha,” and the diversified investor cannot hope to generate alpha as wide diversification makes you mimic the index at best.
The pros and cons of concentration
If you are thinking of concentrating your investments, you need to have both the luxury of time to sit back, read and analyse financial statements and news flow, and also the sharpness of mind and mental capacity to be able to sift through vast amounts of data to come up with logical conclusions. It is not an easy task, and you may be saddled with worries over how each company performs as you will have a significant amount of your portfolio in each company. Without a proper investment framework and philosophy, concentrated investing would not work and may even result in substantial losses.
The upside to having a concentrated portfolio is that if done right, we can expect to generate consistent and sustainable alpha. This is because the combination of skill and the allocation of funds into companies which are more promising than the index would result in an overall better performance, hence leading to alpha.