April 10, 2020
Diversification Is For Idiots*

The main idea of this article is that investors are foolish to diversify unless one of three conditions is met:

The asterisk in the title refers to groups ‘B’ and ‘C’. Not all people who diversify are investing idiots, but the exceptions are rare.

Before we get into this article, let me explain the ‘idiot’ part of the title. Here I’ve chosen to define an investing “idiot” as someone who doesn’t know much about what they’re invested in. I’m not commenting on personal characteristics or anything else. This article is strictly about investing.

I could have used “know-nothing investor” or a less potent phrase, but I chose ‘idiot’ on purpose. We’re over 10 years into a raging bull market, and it’s been a long time since stock market investors have been called idiots. Maybe a reality check for some will be helpful.

PS. I'm not immune to being called an idiot. I’d love to hear why you think *I’m* an idiot for writing this article once you’re done. You can message me on Twitter and share your feedback with me there. I would love for someone to push back on the ideas that follow and pick apart flaws in my logic.

P.P.S. This article is not financial advice. You’re reading the opinion of a stranger on the internet. I know nothing about your personal financial situation. Do your own research.

Anyways, let’s get into it.

What Is Diversification?

Diversification is a trade off. Its purpose is to limit downside risk. In exchange for that downside protection, upside drops too.

When done right, a diversified portfolio can protect investors against some risks. And it will certainly lower the magnitude of outsized returns. An index investor will get the average performance of the entire stock market each year.

While indexes don’t protect against market-wide recessions, and investor funds may still lose value, index investors are protected against poor performance of specific companies or industries. And for the investing idiot, this is an excellent trade-off to make.

Diversifying When You Don’t Know What You’re Doing

Seth Klarman, Author of Margin of Safety, has a saying:

“If you can’t beat the market, be the market.”

Most investors fall into this category, and it’s a totally fine category to be in. Just like most of the world’s population is bad at playing basketball, or teaching physics, most of the world’s population is bad at investing.

For these know-nothing investors, diversifying is almost cheating the system. It’s not often that the worst at something gets a better-than-worse result, but by opting for good diversification instead, investors can achieve these kinds of results. It’s an amazing system for those who recognize that they don’t know much about investing.

Diversifying When You Don’t Have Enough Information

Beyond those who don’t know much about investing, there is another class of investor that diversifies simply because there isn’t enough available information to accurately analyze a business.

Venture capitalists fall into this category.

Some of the brightest minds in finance have flocked to the idea of funding early-stage startups that could one day become massive corporations. This is not to say every VC fund is run by a bunch of idiots. But in the context of predicting the next decade of profits based on a pitch deck and a few meetings with a stranger, VCs know their chances of success are slim.

They simply don’t have much information to go off of. The earlier the investment, the less information is available. While public companies have libraries of quarterly reports, earnings call transcripts, and years of history that can be used to project future earnings, some early stage startups aren't much more than an idea and a founding team. Early stage investors don’t have the luxury of information.

This means they can’t accurately model profits for portfolio companies a decade out into the future. So they diversify. A perfectly reasonable strategy in this situation.

Diversifying When a Business Can’t Absorb Capital Fast Enough

And finally, investors can sometimes be forced to diversify even when they have identified a great business and want to double down on their investment. Some businesses simply can’t absorb all the money investors want to invest.

Warren Buffett spent $25 million buying See’s Candies in 1972. He recognizes it as a great investment decision today, but only because he bought it for $25 million.

Had he instead purchased the business for $50 million or $100 million, his annual return would have suffered. A great investment depends on the price of purchase. This isn’t typically a problem for retail investors, as most public corporations are large enough to absorb their capital without anyone noticing.

But for large funds or investors who invest in small businesses, diversification may be forced upon you.

When Diversifying Is Insane

For everyone else, it’s insane to steal money from one’s best investment to fund a second, third, fourth, fifth, and sixth best.

It makes beating the market far more difficult than it could be, and it’s a confession that you don’t actually understand the investments you’re making. In which case, diversifying is a perfectly reasonable strategy, and you don't know as much about investing as you think you do.

Because anyone who can identify great investments knows how rare they are. They also know that the upside lost to pursuing second-rate businesses is far greater than the improved downside risks that come from diversifying.

Warren Buffett often points to Coca Cola as an example of how rare great businesses are. He says:

“There aren’t 50 Coca Cola’s, there aren’t 20. If there were, it would be fine. We could all diversify like crazy among that group and get the same results. But you’re not going to find it [20 Coca Cola’s], and the truth is, you don’t need it.”

Let’s not forget, the man who said this has held all of his net worth in a single company for decades. A strategy that has made him one of America’s richest people.

But still, some may ask “Why don’t you need more than one great business? What if something happens to the first one?”

Buffett has another great line in response to this question. He says:

“A really wonderful business is very well protected against the vicissitudes of the economy over time and competition”

Essentially, if you’ve got a great business, there’s not much worth worrying about. And if you are worried, you probably haven’t accurately identified a great business.

Whether it’s demand or supply side economies of scale, a well-known brand, patents and IP, corporate structure, or favorable regulations, all great businesses have some sort of moat protecting them against most threats.

And smart investors don’t lose sleep over businesses that are great. Coca Cola has chugged along creating enormous shareholder value for 100+ years, despite countless recessions, depressions, wars, and lots of new competition all over the world.

This isn’t to say that there is zero risk in investing, there is risk in every choice an investor makes. But the diversification trade-off of less downside for less upside simply isn’t worth it for investors who know they’ve got great businesses. Fortunes are created through focus.

All it takes is one glance at a list of America’s wealthiest people through history to figure this out. Without fail, the wealth of America’s richest people has come from a single idea, company, or strategy. Not a spread of 5, 10, 15, or 20.

But for investors who either can’t or don’t want to spend time identifying great businesses, that’s perfectly fine. Make diversity your friend. It’s a really great strategy for anyone who doesn’t know what they’re doing.

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