“Diversification is protection against ignorance. It makes little sense if you know what you are doing”- Warren Buffet
What is diversification?
Diversification is the process of diversifying your investment portfolio with different assets ,with the objective of reducing risk in the overall portfolio.
The theory behind diversification:
The best way to understand the reasoning behind diversification is to look at an example. Let’s assume you decide to start an investment portfolio and you particularly want to invest in the stock market. However, you are concerned that the stock market is high risk and pending a crash. Based on your concerns you seek the advise of a financial advisor. The financial advisor may then advise that you hedge your risk buy investing in the property market as well. Therefore, even if you loose your money in the stock market, those losses can be balanced by your investment in the property market. That is the fundamental idea behind diversification. That by having exposure to different low-risk assets such as property and bonds will the reduce the overall risk in your investment portfolio.
The concept of risk in finance is considerably complex in itself, because risk is what nobody wants with their investments yet it can never be eliminated.It can be reduced and managed by never eliminated and at times attempts to reduce risk can create even more risk. Suppose in the example mentioned above that you opted to invest in the stock market and also opted to invest in the property market, and both this markets fall? You lose your money in two markets, oppose to if you invested in one market. So your overall risk would not have been reduced. Therefore if done recklessly diversification can cause more damage than good.
Why Warren Buffet thinks diversification is stupid?
The tenants of great investors such as Warren Buffet, Bernard Baurch and George Soros is to invest in concentrated positions. Often when people start investing they make the mistake of building a portfolio with way too many assets in their portfolio. The more random your portfolio is the more risk and exposure your portfolio will have. Ideally starting off as an investor you should not have more than 3 to 4 assets in your investment portfolio. The benefit of having a more concentrated investment portfolio is that you gain a better understanding of the companies or sector that you are investing in.
“It is unwise to spread one’s fund over too many different securities” “Time and energy are required to keep abreast of the forces that may change the value of a security. While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues” – Bernard Baruch.
How to diverse correctly?
Diversification is still a necessary means to reduce risk. There are fancy formulas that you can learn and apply to reduce risk in your portfolio. But as an individual investor who is building a personal portfolio you do not need to be concerned with the technicalities of risk management. What is important is that you do not put all your eggs in one basket, and you do your due diligence before making an investment.