Don’t over-diversify if you want spectacular investing returns

The conventional wisdom is that diversification is an integral part of successful investing. Although the idea of diversification has been around for centuries (and is mentioned in both the Bible and the Talmud), the modern idea of financial diversification can be attributed to the work of Nobel prize-winning economist Harry Markowitz and his Modern Portfolio Theory. We won’t get technical here and we by no means will cover anything in depth, but it’s a good idea to realize that too much diversification will prevent a portfolio from achieving great returns.

For most people who are not in the game to get amazing returns (who are in it to protect and grow their money at a reasonable pace), broad diversification is a great idea and will likely protect them. For those individuals who are in the game to make spectacular returns (and who should be able to tolerate more risk), diversification beyond a certain point makes them worse off. I’m not sure exactly where that point is. Some people say ten investments or stocks and some say a little more or a little less. Warren Buffett has stated that six is a good rule of thumb.

Whatever the number, the important thing to understand is that if a portfolio has too many stocks an amazing performance by a single stock gets diluted. If a stock goes up 10x (a ten bagger as Peter Lynch would call it) and it represents only 1% of your portfolio, your portfolio only goes up by 10%. The stock went up 1000% but your portfolio only went up 10%. If you want to make spectacular returns, energy must be focused on picking great businesses to invest in and discipline must be exercised to not overcrowd your portfolio.

Additionally, a part of diversification involves investing in different sectors (eg. energy, healthcare, financials, etc.). However, why would one need to invest in one hundred businesses in every sector? Wouldn’t it seem wiser to invest in the best businesses in each sector?

Again, this isn’t meant for individuals who dabble in the stock market, who can’t tolerate the risk that comes with investing for spectacular returns, or who don’t have either the time or the inclination to research businesses in an in-depth way. However, if you want to make great investing returns don’t over-diversify and do your best to stay focused and disciplined on high-quality investments.

It’s key to not that this entire discussion only applied to advanced and experienced investors – novice investors or investors with a moderate level of knowledge and experience should not attempt to pick individual stocks. Novice investors and moderately-experienced investors will be best served by sticking to good mutual funds and ETFs. ​

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