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How Diversification is Making You a Bad Investor

“The idea that smart people with investment skills should have hugely diversified portfolios is madness. It’s a very conventional madness. And it’s taught in all the business schools. But they’re wrong.” Charlie Munger

By Arsalan HaroonPublished 2 years ago 6 min read
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How Diversification is Making You a Bad Investor
Photo by Wance Paleri on Unsplash

Most business schools and academics teach business students, That investor should diversify their portfolios into 30 or more stocks with different sectors and industries.

According to academics, the main reason behind diversifying is to reduce the risk in your investment and not depend too much on one sector.

For example, if stock from one sector dont performs well in your portfolio, Then you may have stocks from other sectors that may go up in value. It balances your portfolio risk and returns, so you don't lose much.

The problem with diversifying your portfolio is that you may reduce your chances of losing money. But you also reduce your chance of making above-average returns in the stock market.

Diversification is one of the reasons most fund managers don't beat the market return because they are widely diversified.

This may reduce their probability of losing money, But it also reduces their return on investment.

If you have neither the passion nor time to pick individual stocks, Then you will be better off buying an index fund like the S&P 500.

It gives you a market return, and your investment is diversified into the 500 largest companies in the united states.

But if you are an active investor who understands how to value companies, And is passionate about picking good business.

Then, it doesn't make sense to diversify into hundreds of companies.

If you are passionate about investing in businesses and willing to take risks to achieve higher returns. Then diversification is not for you, and it may stop you from reaching your investment goal because it reduces risk, But also bring down your return with it.

Let's learn some of the reasons why diversification is bad for active investors.

It's impossible to know everything in great detail about 30 or more different businesses

Most individual investors can't know in detail about every 30 or more businesses they invest in.

It will be challenging for investors to keep themselves up to date on 30 businesses and make sound investment decisions on all of them.

It's better to know a few businesses in great detail and invest in them rather than investing in 30 businesses that you know little about.

If you look at successful investors like Charlie Munger and Warren Buffett. They usually put a significant amount of capital invested in very few good businesses because they know about that business in great detail, Which increases their chances of making above-average returns.

Berkshire Hathaway had 40% of its stock holding in only apple stock as of July 2022.

When you invest in 30 different businesses. It is harder to make above-average returns because not every 30 businesses will perform better.

But those who perform better will have little impact because you don't put your large capital into that stock to reduce your risk exposure.

The investor would be better off understanding a few good businesses in great detail, which can more likely give above-average returns than investing in 30 businesses that you won't know about in great detail.

If you want an average return, buy an index fund like the S&P 500; you will get a more desirable return than investing in 30 different businesses.

Low risk = lower returns

Most academics and professors tell students that diversification reduces their portfolio risk and, it also reduces the return on investment.

Investors' goal is to maximize their return, so if diversification reduces the return. Then why do investors still do it?

Most investors sometimes don't want to take high risks and rewards. Diversification reduces their chances of losses in the market.

But the problem is that it also reduces the return on investment, while the goal of any investment is to maximize return on investment. So diversification essentially lowers the chances of gaining good returns.

You can still lose money with a diversified portfolio

Most people who believe in diversification think that investor shouldn't put all their eggs in one basket.

So if one stock in your portfolio goes down, you would have another stock that may go up. So it reduces the risk of losing money.

But you can't eliminate the risks. You still have the systemic risk, Which is when all the markets go down. Then your diversified portfolio will also go down with it.

Although you reduce your risk of losing money, you can't eliminate the risk, and many people still lose money even if they diversify their portfolios.

If you widely diversified your portfolio during the 2008 great financial crisis. Then your portfolio went also down with the market because every security was going down.

It shows that diversification doesn't protect you from losing your money during financial crises.

Diversification is a reasonable choice for people who aren't interested in the financial market and are satisfied with the average results by buying index funds which can most likely build wealth.

So let's learn what kind of people should diversify their portfolios?

People who don't have any knowledge about investing

If you dont know anything about investing. But want to build wealth in the financial market.

Then diversification is a good choice, Instead of buying individual stock and diversifying it.

You can buy an S & P 500 index fund. It can invest your money into the 500 largest companies in the US.

So just buying an S & P 500 index fund can give you instant diversification, and you can get market returns that most fund managers cannot beat in the long term.

Regular working people who don't have time and passion to manage portfolios actively

Most regular people don't have time to actively manage their portfolios. So it's better to diversify their portfolio and invest in index funds like S&P 500 that don't require you to do much and give you good market returns.

Studies and historical data have shown that the S & P 500 index usually goes up in the long term.

It's usually good for regular working people to invest in S&P 500 to get a good return which few fund managers beat in the long term.

Conclusion

Diversification can be good for investors who don't know anything about the market or don't want to pick stocks.

But diversification can be bad for the active investor who picks individual stocks because it not only reduces the risk. It also reduces your probability of getting higher returns.

So as an active investor, if you are picking a stock. Then diversifying into 30 or more companies would reduce your chance of increasing returns.

You should buy a few good businesses that perform well and learn about them in great detail.

When you invest in only 4 or 8 stocks, you will know more about them in detail. It also increases your chances of getting a higher return.

Wide diversification is only required when investors do not understand what they are doing. - Warren Buffett

Originally Published On Medium

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About the Creator

Arsalan Haroon

Writer┃SEO Expert┃Investor

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