Investment Princple Articles
Articles are written with the goal to educate and simplify the
fundamental financial and investing topics. Information gathered for these
articles are researched from credible websites, texts, and notes.
Merits of Non-Diversification
This is a direct undermining of my previous article ‘Diversification and EPT’
but is still important nonetheless. In ‘Diversification and EPT’ I laid the
principles for modern portfolio theory built on diversification. That it is
beneficial to a rational investor to diversify and spread risk, thus increasing
the amount of return for given risk. This is a tried and true fact, but it can
also handcuff an investor’s returns.
As an investor adds various stocks to their portfolio the benefit of each stock
added is diminished. These diminishing benefits are relational and incremental,
resulting in a downward sloping line. It is generally held that once a portfolio
reaches around 11 different stocks it has nearly wiped out all unsystematic
risk.
Thus, if someone has a portfolio of 20 different stocks they are diversifying
away the benefits of the better performing half of their portfolio. Therefore it
would make more sense to a rational investor to hold a portfolio of around 10
different stocks to enjoy the benefits of diversification and to invest heavily
in a couple stocks they truly believe to be winners.
This sentiment is echoed by the Oracle of Omaha himself, Warren Buffet, at the
2008 Berkshire Hathaway shareholders meeting when he said “there are situations,
for the full-time investor, where it’d be a mistake not to invest 50% of your
net worth in one business.”
While I personally may not advise an investor putting half of their net worth
into a single business, 25-35% wouldn’t be a stretch. The point is for an
investor to trust their judgment and analysis and to go for the big return
sometimes. You may miss and lose a decent amount of money, but it is often
easier to recoup 25% of your worth than to miss out on a possible 500% increase
(while kicking yourself in the head the whole time). While no one else may have
the analysis ability of a Warren Buffett, we can all learn from his principles,
where even if we hit and earn only half of what Berkshire
does we will certainly be enjoying higher than average returns.
