Diversification is for Stupid

by | Feb 6, 2019 | Learning Module 2, Topic 1: To diversify or not, Student's Q&A | 0 comments

Q: I came across this video today, please have a look at it  https://www.youtube.com/watch?v=ibSp1xzLfy8

As per my understanding, it basically argues against diversification and therefore the Modern Portfolio Theory. I do understand that it comes with a lot of conditions but does it have any merit especially since it comes from the best of the best. It challenges the now conventional wisdom and something that a lot of asset managers do, i.e., they diversify. Diversification seems to have a sound mathematical argument in terms of managing risk and but this video argues against it and that too is not such a good manner.

I would like to have your views on this.

I was in your Investments class in December 2017.

Sincerely,

Ankit Rathore

 

A: Hi Ankit,

thanks for writing, pleased that you thought of writing me. You may recall my mentioning diversification versus concentration multiple times in classes. The way I have tended to say it is that if diversification means NOT putting all your eggs in one basket, then an alternative is to actually put ALL your eggs in a basket and watch that basket carefully.

The latter is passive investing, meant more for people who do not have either the ability or the interest in doing their homework of analysing businesses and deciding which of their financial assets to include/exclude in their portfolios Hence they outsource it to some fund manager and hope to achieve market returns over the long-term. Homework then reduces to picking the right mix of managers rather than business. Even more passive is to eliminate the manager and buy index funds, which is a trend that is more common (in India through SIPS and elsewhere as the said fund managers haven’t on average performed as well. What I have said in class is that, if you are one of those people, then you don’t really need a class like mine. In this sense, of course diversification is quite mindless. But I wouldn’t call them idiots…

Being concentrated tends to mean owning fewer things and/in larger sizes. But it does involve studying a handful of businesses very carefully, doing the homework and becoming comfortable with them. Munger and Buffett are good at studying businesses, so of course they are going to say the latter. Even Mark Cuban is doing homework and then putting his money in selected and analysed firms and securities. This guy is savvy enough to play index options and time markets, again not what the average individual knows how to do.

Thanks and keep the questions coming.

Badrinath