You need to diversify. Sounds familiar? Perhaps, you’ve heard this advice many times from the world’s top investors.
Several investment professionals agree that even though diversification doesn’t really guarantee no loss in your investment, it greatly helps investors achieve long-term financial goals through minimizing risk.
The market is unpredictable and volatile, and diversification battles against this by spreading the risk across various types of investments. To put it simply, there is no certainty on who is going to win a race, and so you bet on everyone. A sure win.
As the old and cliché saying goes, “Don’t put your eggs in one basket.”
Yet, there are also investors that say you should hold only a few stocks that you know very well. If you diversify, then you are just owning mediocre companies.
Both parties have a point.
Now, let’s see how great investors like Warren Buffett, Peter Lynch, and Mohnish Pabrai perceive diversification, and from their frame of reference, how many stocks should an investor hold in their portfolio.
Peter Lynch on Diversification
Peter Lynch is against diversification calling it a big mistake. “I don’t believe in diversification at all. I would only hold one stock if I could find one great stock. Diversification is a big mistake; I call it die-versification. You balance this thing with another thing and they both go down. So, I don’t believe in diversification, and I would own one stock,” Lynch stated.
“But what I do believe in is if I find ten good stories, they’re all equally attractive, I buy all ten, and I want to see it unfold like watching ten poker games. You watch cards turn over, story three get a better story, story six slips, story seven slips but it goes up 50%, you sell seven and buy two. That’s all I do. If they’re equally attractive I buy all ten,” he added.
Lynch prefers owning just one great, or “quality” stock if it was the only stock that he can find good at a time. But, if he finds ten good stories, he will probably buy all of those ten. Once he finds the best story among the ten, he will mount up on that.
The American investor doesn’t care much about having one stock occupying a huge percentage of his portfolio.
Lynch is saying that diversifying stocks just for the sake of diversification doesn’t sound right. If there’s really only one good stock, and the other else is just average, then buy only the good one.
Warren Buffett on Diversification
Warren Buffett’s belief about diversification is pretty tied up with Peter Lynch’s— he, as well, believes that diversification safeguards people who don’t have enough knowledge in analyzing business values.
“We think diversification is as practice generally makes very little sense for anyone that knows what they’re doing. Diversification is the protection against ignorance. If you want to make sure nothing bad happens to you relative to the market you own. There’s nothing wrong with that. That’s a perfectly sound approach for somebody who does not feel they know how to analyze businesses. If you know how to analyze businesses and value businesses, it’s crazy to own 50 stocks, or 40,” Buffett stated.
Investors don’t really have much time to spare, and there’s no way they can carry on with about 50 companies comprehensively. You will not be able to follow every single happening in each and every company to confidently invest in them.
However, although Buffett doesn’t really believe in too much diversification just like Lynch, he pointed out one important thing that Lynch missed about diversifying stocks.
“Diversification is protection ignorance” might somehow sound like a strike as if saying that those who diversify have no extensive knowledge about investing in good businesses, however, Buffett really thinks that it is a “perfectly sound” approach for some people.
While Lynch thinks that it doesn’t really make sense at all, Buffet thinks that if a person is an active investor and critically selects stocks, he/she should invest in, then diversification might somehow work.
If you are a passive investor who only wants to gain an average market return, then diversifying really be is a really an excellent strategy to mitigate loss in the long run.
Passive investing is the most accepted investing strategy in the world. Hence, if you will follow that approach, ignorance will be to your advantage. Perhaps, you can even do better than people actively invest in individual stocks.
Mohnish Pabrai on Diversification
“If you look at most entrepreneurs, they only have four bets, 98% of their assets is one bet and they don’t have sleepless nights. They’re pretty comfortable with a single bet. A lot of eggs in one basket. If you don’t know what you are doing, please index. Pretty honorable way to go through life and you’d still have the power of compounding. But if you know what you are doing, then it seems like insanity to own 30 stocks or even 20 stocks,” Pabrai expressed.
The Indian-American investor placed everything so well.
If you know someone who has a business where all of their eggs just sit prettily in one basket, then that’s good. It’s too risky to sell their business just to buy and spread their assets all over.
Pabrai highlighted that you will have a harder time fully understanding businesses you invested in if you have quite a lot of stocks in your portfolio.
Diversify: Yes or Not?
Putting your eggs on only one basket may seem to be so risky, but Warren Buffett has stated that betting on one good stock could be a better and safer choice than forcing yourself to diversify funds.
Warren Buffett stated, “A wonderful business is very well protected business against the vicissitudes of the economy over time and competition. We are talking about businesses that are resistant to effective competition, and three of those will be better than a hundred average businesses, and they will be safer. There is less risk in owning three easy to identify wonderful businesses than owning 50.”
Technically, there’s really nothing wrong in diversifying IF you fully understand the business, the industry you’re entering, the business management of the company, and especially if you are highly believing in the future growth of the business.
However, if you will jump into average businesses that you don’t understand well, then you’re at a higher risk of losing your funds.
The number of stocks you should own isn’t restricted to just one extremely good business, but you should never have too many. Only buy high-quality companies which you understand thoroughly and in-depth.
If you can only handle three, then just have three. But if you can handle more than that, it’s okay as long as you know what you are doing, and where you are heading.
