“Diversification is the only free lunch on wall street” Anonymous
Modern portfolio theory lavishes praise on diversification. The basic thesis is that while higher returns require a higher amount of risk; diversifying or spreading your risk across different assets with low correlation to each other can give you high return with lower risk. So, instead of a handful of US equities, the entire US market is a better diversified vehicle. Combining international and emerging market equities to US equities lowers your risk for the same return because international/emerging equities have low correlation to US equities.
Legendary investors like John Bogle (Founder of Vanguard) swear by it. Ray Dalio describes the diversified “All Weather” portfolio. Ben Graham said, “Diversification is an established tenet of conservative investment”.
This idea of same return for lower risk extends to life. You hear people talking about creating multiple uncorrelated income streams (e.g., salary, rentals, etc.) to reduce risk exposure to any one stream (e.g., losing your job). Or, not having both spouses work in the same company or industry.
I recently read Warren Buffett’s delightful biography “The Snowball – Warren Buffett and the business of life“. In the book Buffett, the legendary investor and CEO of Berkshire Hathaway, makes the case against diversification.
He talks about the “20 punchcards approach”. If you could make only 20 investments in your lifetime. You would resist the urge to dabble. Make few good and big bets. He has famously said “diversification is only required when investors don’t know what they are doing“.
On the surface Buffett and modern portfolio theory seem to be at odds. If we dig deeper it is not so.
All great fortunes have been made through focus. From Rockefeller with oil to Bill Gates with software. From Buffett with investing to Bezos with e-commerce. Being great at something and putting all your energy into it – that’s the formula. If you are really good at something and know what you are doing concentration is a better approach.
Concentration creates rich assets – in business or in life.
However, the process of preserving rich assets is a different story. It requires preparing for the uncertainties of the future. And, preparing for a wide range of uncertainties requires a diversified approach.
“Concentrating your assets can make you rich. Diversifying your assets will keep you rich”