To Diversify Or Not To Diversify

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Publish date May 11, 2011 Views: 547 Comments: 7

That is the question.

For most small-time investors, diversification is necessary. Index funds offer diversification across a type of investment, and with a strategy like this, you can be sure you’re avoiding investment management who, on a whole, perform worse than the indexes. Diversification through index funds allows investors to spread small amounts of money over a wide variety of investments. This doesn’t necessarily reduce risk, but it does mean that an investor in a diversified fund won’t be exposed to any one stock’s decline.

Imagine an orchestra with 80 musicians. For an orchestra to performing well, 100% accuracy is required from the entire group. When all musicians are playing together, however, one musician neglecting to play may not be noticeable. The diversity of instrumentation means if one violin out of a section of five forgets to play one measure, the other four will likely provide enough volume to hide the problem.

When it comes time for the violin solo, forgetting to play one measure is a big problem. There is no coverage from the other violins to cover the mistake. Investing a significant portion of your money in one company is like playing a solo. There’s no buffer to protect you if you make a mistake.

Nelson Petz is an asset manager in charge of a multi-billion dollar partner. He claims that diversification is for sissies. In this case, that would be violinists not prepared to perform a solo.

It’s true that focusing on one company can provide much better returns than investing in a broad cross-section of stocks. But here’s the difference not fully addressed in his Fortune Magazine interview: Nelson can invest enough money through his management firm that he has the power to change the operations of that company. When he puts his support behind a company, it’s because he knows the company’s management is not living up to its full potential. With enough money, he can influence or change management.

On the other hand, the less financially endowed investor who does her research and puts the bulk of her investment into an established country is in trouble. She puts all of her money at risk. Even with the knowledge of how the company could improve its performance, unless she has invested enough funds to influence management, she is still at the whim of the company.

Diversification is for people who may not have access to enough money to influence the outcome of their investment.

Photo: *L*u*z*A*
Fortune Magazine

Article comments

7 comments
Anonymous says:

I agree, but to me these two investment strategies aren’t even comparable (ie what he’s doing and what we, the average investor, do).

He’s focused on taking an active position in the companies he invests in, and hoping for an event (like an acquisition) of one of those companies he owns so that the share price increases, aka “Event Driven” investing strategies, a subset of mergers arbitrage. So when we’re talking about event driven investing, I do agree with him that it’s better to have a concentrated, high conviction, portfolio.

But the average investor isn’t in the event driven investing business, that’s a completely different investment strategy (and skill set!) So yes, we definitely need to diversify.

lynn says:

It’s common sense to deversify. We use a fancy word for it, but generations past put it best with their quaint sayings. Don’t put your eggs in one basket comes to mind here.

skylog says:

some advice does indeed stand the test of time…

Donna Freedman says:

If you don’t diversify, you’ll fall a lot farther — and land a lot harder — should the “sure thing” turn out to be a bad deal.
I don’t pretend to know finance in and out, but “don’t put all your eggs in one basket” just makes sense.

Ceecee says:

I like the orchestra analogy…..Diversification has helped my teeny portfolio more than once…..when oil was tanking, tech was rising, etc. It is hard to do, you tend to favor one sector over others, but it seems necessary.

tbork84 says:

That’s a great point that many of the small fish tend to forget. The shares that we own are stakes of ownership, but not enough of a stake to make any difference in how the company is run.

Anonymous says:

Protect yourself… from yourself. Diversify your primary accounts – 401(k), Roth or other retirement funds, and speculate with a small side account. That way, if you suck as a stock picker, you don’t lose your shirt. Plus, you’ll learn a heck of alot.