DON’T PUT ALL YOUR EGGS IN ONE BASKET
Many investors swear by diversification. Spread your investments across a range of assets, and you’re less likely to lose money, right? That’s the theory I followed when I first started investing. After years of interacting with fellow retail investors who have outlier results, I’ve come to question this commonly accepted investment axiom. Could diversification, while beneficial for large investment funds, be less effective for individual investors?
Diversification is typically viewed as a way to lower risk. Read any investment guide, and it will likely point out the importance of spreading your bets in a portfolio. Some even provide mathematical proofs to support this strategy. I know math more than most people, I did my undergrad in math. On the surface, it seems logical—spreading your money across several assets can protect you from major losses.
But Diversification, it seems, is incomplete. It’s not an axiom but rather a crutch. In a world where many diversified investors struggle to even match the index returns, can we really say this commonly recommended strategy is effective?
The market often rewards outliers. Major gains frequently come from unconventional strategies held over long durations[1]. The main challenge is not about arbitrary intelligence but the counterintuitive frame of thinking. Top investors consistently navigate this maze. People listened, but rarely changes behavior and mindset accordingly. While there are countless lessons on how to invest, perhaps the most crucial insight for investors is discerning what to unlearn.
Do not outsource your judgment. Making investment decisions on your own is tougher than it seems. It’s common for individuals to lean towards stocks recommended by seemingly credible investors—our brains are conditioned to trust established sources of knowledge. Think of the school days: you relied on established curricula and aimed for top grades. Similarly, in scientific research, we build upon previous established work. This conditioned trust, however, can be a pitfall in investing. When numerous investors flock to a stock based on popular endorsements, it can drive the price up, leading to overvaluation and diminished future returns. That is where the hard part of deicion-making comes from, people confuse stubbornness with independent thinking, truth with myth, price with value.
Resist impulsive reactions. When changes occur, humans naturally respond to adapt. While this instinct serves us well in many scenarios, in investing, impulsive reactions can be detrimental. Investment actions should hinge on current fundamentals, not external triggers like mere price changes. Many have suffered losses by reacting hastily to a price drop, without considering underlying factors.
Do not follow the big players. Copying investment strategies of Warren Buffett is not the best approach for retail investors. But why is that? Different sizes of asset management have totally different constraints and incentives. For instance, the strategies of large funds are dictated by factors such as their fund size relative to stock market capitalization and trading volume, alignment with economic cycles, and quarterly performance benchmarks. Most of these constraints are irrelevant for retail investors. Thus, retail investors should tailor their strategies to their unique advantages and limitations.
Risk management. Truly grasping the inherent risks in investing is pivotal for the top percentile returns. If outlier performance doesn’t intrigue you, simply buying index stocks could make you outperform even most funds – a simple solution that already exists. However, for those who delve deep into in intrinsic nature of risks, it boils down to an individual’s comprehension and perception of the stock. Contrary to popular belief, the primary strategy for risk management might not be diversification. Let’s explore this with an example:
Consider an analogy for portfolio diversification where you’re a student facing an unlimited True/False exam within a time constraint. Your final score is a weighted average of correct answers.
If you’re confident in the material, it might be best to pick and answer one question that you’re certain about - resulting in a potential 100% score. Similarly, in investing, if you’re confident about a particular stock’s performance, you might invest heavily in it, disregarding other options.
For those who know a bit about many questions but aren’t fully confident in any, the strategy is to attempt multiple questions to hedge the risk of scoring zero. This mirrors investing in a mix of stocks to mitigate the potential loss if one stock underperforms.
If you lack knowledge of the subject, randomly answering many questions might still net a near 50% score due to the law of large numbers. However, merely achieving average results rarely leads to profits in investing. Alternatively, you can take a high-risk strategy of betting on a single question, hoping for a perfect score. In investment terms, this equates to either diversifying investments across many stocks, which may yield mediocre returns, or risking everything on a single stock, based on luck rather than informed decision-making.
So, what is portfolio diversification at its core? It’s a risk-mitigation approach, tailored primarily for the unique challenges large funds face. Some funds are even bigger than the market capitalization of numerous stocks, necessitating distribution across multiple investment targets. Granted, these entities might have better insights due to their access to timely, structured, and accurate information. However, their drawbacks are equally significant. They might experience illiquidity due to large holdings and exhibit shortsightedness because of benchmark-driven pressures and fund cycles. Portfolio diversification emerges as the strategy tailored for these specific constraints.
Retail investors typically don’t face these same constraints. Instead, they should tailor their strategy based on their unique circumstances and the advantages they have over large entities. For example, liquidity, agility, time horizon, concentration, etc. While this essay doesn’t offer financial advice, one potential direction for shaping a risk management strategy is to consider long-term, concentrated investments, which stand in contrast to the principle of diversification.
Portfolio diversification, while often touted as a prudent strategy, is frequently used by funds as a sales tactic. By presenting investment as a complex landscape where diversification is key, these funds subtly encourage investors to entrust their money to “professionals.” The approach isn’t necessarily wrong, but it’s primarily tailored for the constraints of large funds. Think about it: if a fund manager put all their assets in just one or a handful of stocks, many would question their expertise or even wonder, “Couldn’t I do that myself?” This perception reinforces the idea that proper investment is intricate and multifaceted. While holding onto a stock through its fluctuations can be a test of resolve, a concentrated approach might seem too straightforward, diminishing the perceived value of fund managers in the eyes of potential clients.
In conclusion, prioritize your own research. The best defense against risk is thorough due diligence. Once you grasp the often counterintuitive dynamics of investing, and weigh the advantages and disadvantages retail investors have compared to large funds, especially in the context of portfolio diversification, it’s vital to assess your personal stance and temperament. From there, recalibrate your investment decisions and strategies accordingly.
[1] My emphasis on the long term assumes the goal of investing is sustained financial growth. If you’re more of a short-term speculator (even if you don’t identify as one), please skip.