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.
Published or updated May 11, 2011.