Diversification vs Concentration

July 17, 2023

The old question of diversification vs concentration and which is best, especially as we end 2022?

This debate largely depends on several factors (knowledge, time, goals etc.) and will be different for each investor.

Most finance academics and professional prescribe diversification over concentration as it might be the only "free lunch" in investing. Some of it has to do with the finance literature which equates risk to volatility. A stock that moves more has more inherent risk, this captured by a stock's beta. So, if you increase the number of stocks in your portfolio you should be able to reduce the volatility of your portfolio i.e., reduce risk. Some go even further and suggest that an investor should not only diversify by increasing the number of stocks in your portfolio, but also diversify by investing in different asset classes e.g. cash, bonds, real estate etc. 

On the other hand, investors that believe in concentration implicitly reject the efficient market hypothesis. The idea is to invest in a few companies you know well and by focusing on your best ideas you should be able to outperform the market. Their view of risk is slightly different and has little to do with volatility. Risk is viewed as the risk of permanent loss. Diversification is for the "know-nothing" investor and essentially protection against ignorance. 

Warren Buffett is the most successful concentrated investor while Peter Lynch is the most famous investor following a diversified strategy.

To determine which strategy suits you best you need to have a grasp of your investment acumen, dedicated time towards investment activities and financial goals. Remember for each investment decision you are effectively saying that you know something the average investor don't whether it is buying or selling. 

For example, a new investor that's close to retiring and dispassionate about investing should probably follow a diversified/passive investment strategy while an investor willing to spend a lot of time researching stocks with an independent view, goals of outperformance and no immediate need for money should probably consider a more concentrated/active strategy. A word of caution, just because you have a long time horizon does not imply that uncalculated risky investments are excusable perserving your money should always be top of mind with each investment decision.

There is no right answer when it comes to diversification/concentration. To determine whether you want to be more diversified or more concentrated you have to know your investment knowledge, goals and, most importantly, you have to be comfortable with your investment style.

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