Are you afraid you may lose something valuable?

photo taken at Bhigwan lake, Maharashtra, India by Prateek Kumar

“Diversification is protection against ignorance. It makes little sense if you know what you’re doing.” — Warren Buffet

Think diversification!

Diversification is applicable to investments surely but equally applicable to career, life, relationships, even the number of kids one has. And not just applicable but is critical for long term success.

Several years ago, I struggled to appreciate the need for or value of diversification. If I knew that a certain stock or fund is going to do well, why would I ever want to invest in an uncorrelated stock/fund as well — it does help when price of my stock falls, my entire portfolio falls proportionally but what about when my stock goes up — diversification limits the upside. When my goal is to grow my wealth and I am confident in the growth potential of my chosen stock(s), why would I moderate it by diversifying?

You have a great team member who is ambitious and capable — would you diversify her potential by hiring another person who has uncorrelated qualities? In a world with no limitations on budget, you may but what about in real world where you work with limited budget.

If you are starting out your career or investment journey and let’s say you come from limited means and privileges (most of us are from limited backgrounds only!), would you think of leveraging and relying on your ambition and capability or diversifying your potential? (rhetoric question alert!).

I believe diversification is powerful and useful but certain conditions apply. If you think a little critically about how diversification creates value, it can be judiciously applied — this is in contrast with applying diversification as a best practice which may actually work against you many times.

Here are few observations about diversification

• Diversification is a risk mitigation method
• Diversification is a defensive strategy
• It gains importance only when after you have something valuable that could be lost
• Most leaders and successful people make highly concentrated bets — they do not diversify much
• In the face of limited knowledge or uncertainty, diversification helps
• Diversification could be costly — growth potential is expended to acquire diversification

Nature is the ultimate diversification machine. What it intends to protect is life. Multiple offspring is but one example of nature’s diversification. An average fish lays thousands of eggs. An average dog’s litter size is over 5 puppies and average litter size of a cat is 4–6. Post pastoralization and agriculturalization of human societies, we moved from having 10+ kids to today’s 1–2 kids generally. Earlier child mortality used to be high and hence one did know who or how many will survive past the age of five — today mortality has improved significantly and hence no need to diversify as much.

If you let your bank relationship manager counsel you on wealth creation, sooner or later they will talk about diversification — it typically will take the shape of diversification for the sake of diversification — you know because it is a best practice (read about ambivalence of best practices here).

While stock investment is probably the best way to create wealth in the long term, one should engage in stock markets. But stocks are individually risky — so buy mutual funds or index funds instead. Now, diversify away fund manager risk by investing in multiple funds. Also diversify across market caps. Why not diversify away geographical risk — invest in international funds. Diversify away risk from “equity” products by investing in REITs, bonds, fixed Income funds, hedge your portfolio by investing in gold etc.

Diversification works when you have something to lose and when you have little control over factors that affect the loss. So, diversify away risk but also remember that diversification comes at significant cost (in terms of growth potential) — this means diversify to the extent that it does not become too costly. Given that perception of risk is more a subjective matter than an objective parameter, cost threshold of diversification will also be subjective. Be very wary of over-diversification.

“The idea of excessive diversification is madness.”- Charlie Munger

Now, consider these

• At the end of 2021, Apple stock accounted for 47.6% of Berkshire Hathaway’s portfolio
• If my conservative calculations are right, 60% + of Jezz Bezo’s net worth is tied up in Amazon stock
• Most rich people made their riches not by diversifying but by concentrating

Although many people seem to believe that they are risk averse and would rather diversify, they end up making most concentrated bets with their time. Either they tie their long term success to a career or they become entrepreneurs building up one or two or three firms in their lifetimes.

I had a long journey in my relationship with diversification. Here is what I have done in my life or how I view things now

• With deeper and sharper knowledge, one can develop conviction in their pursuits. This leaves them with fewer aspects of their pursuits to be diversified away. For example, if you don’t spend time in understanding why equity investments are among the best options for long term wealth creation, you may set aside very little allocation of your wealth/portfolio to equity. Whereas if you understand how equities work, you will feel confident in higher (or more appropriate) allocation to equity but given that stock picking is a different ball game, you may engage in mutual funds or PMS products
• Unless you get to a certain level of wealth, there is no point diversifying certain risks — for example, geographic risk. In my personal case, I do not intend to diversify away country risk — not that I do not believe in this risk but because I do not have sufficient enough wealth to worry about this risk. In other words, I do not have much to lose to worry about this risk
• Long time back I learnt from subramoney.com that salaried employees should diversify by investing in “equity” products whereas business folks with variable income (but with potential for occasional windfalls) should diversify their risk of variable cash flow by investing in fixed income instruments
• Diversification results in diversity and diversity could result in diversification. So, if you want to be sure, focus on diversification — diversity will take care of itself
• Critical factors to consider for diversifying:

1. Is there something valuable to lose?
2. Did I build sufficient knowledge to account for systemic risk
3. Are there random unknowns that could negatively affect this value?Is the timing of known factors random?

To conclude, I believe diversification is essential when you have something valuable that could be lost but right kind and amount of diversification is the call of the need — not any diversification.