Diversification is for incompetent idiots! Bill Gates didn't get to where he is today by diversifying!
Those words were rudely shouted at me by a hedge fund hotshot at an investment conference a few years ago. I must confess, had I been statistically illiterate (as many in the audience were), I'd have been tricked into agreeing with him. After all, it's true - Bill Gates didn't become one of the richest people in the world by diversifying. Neither did Warren Buffett. In fact, Forbes' wealthiest people list is almost entirely made up of individuals who, like Gates and Buffett, had been spectacularly rewarded for putting all of their eggs in one or a few baskets.
But before you attempt to follow in their billionaire footsteps by betting your life savings on the next Microsoft, don't forget check out the cemetery. Because when you do, you'll see a massive graveyard full of unlucky people who, just like the tiny population of life's lottery winners, also put all of their eggs in one basket and ended up with nothing. To ignore these losers is to be fooled by survivorship bias. It's financial suicide!
Indeed, concentrating your bets works fine - in theory. If you know exactly which stocks will offer the best returns, it makes total sense to only bet on the few that will give you the best bang for your buck. But we don't have a crystal ball. In our world, the "real" world, the future is clouded with uncertainty. Events rarely unfold in the manner that even the smartest investors, aided by sophisticated mathematics and ever increasing computing power, think they will. Sometimes the safest-looking stocks turn out to be the riskiest, and vice versa. Such randomness can cause serious damage to under-diversified portfolios.
Some are destined to learn this lesson the hard way, unfortunately. Like the fund manager I mentioned earlier. He ended up joining the graveyard of losers when his fund blew up during the 2014 oil price collapse. Looks like putting all of your eggs in one oily basket isn't so wise after all. Bill Ackman should heed this advice. His fund is currently suffering catastrophic losses, all because of an oversized bet on a pharmaceutical company using questionable accounting practices. But the professionals aren't the only ones guilty of under-diversification. A major reason why most retail investors underperform index funds is because the average investor holds just four stocks. Some under-diversify even further by only holding the stock offered by the company they work for (Enron employees made that mistake).
The problem here isn't that all of these unsuccessful concentrated investors are terrible stock pickers. Many of them might actually be extremely skilled. But skill alone doesn't guarantee success, at least not in investing. It's important to not confuse investing with skill-dominant activities like, say, chess. In chess, the grandmaster will consistently beat the lucky amateur. In investing, on the other hand, luck often wins out over skill. This was famously illustrated when a bunch of Playboy Playmates randomly picking five stocks each were able to beat Wall Street professional at their own game.
While it's impossible to completely eliminate Lady Luck from investing, diversification can significantly weaken her influence. To understand why, remember that variability goes down as the sample size grows larger. An outlier stock can swing performance wildly in a concentrated portfolio; in a diversified portfolio, these extreme swings will have less of an impact on overall performance. In other words, diversification protects you from the extreme lows, but you aren't going to win the lottery either. On the whole, you'll achieve a good return (which is what matters).
This "luck factor" is also an important consideration when choosing who to invest your money with. Say you have the option to choose between two money managers. We'll call them Mr. A and Mrs. B. Mr. A is a concentrated value investor who likes to purchase a small group of undervalued stocks and hold them for a long time. Needless to say, Mr. A doesn't trade very often. Mrs. B, in contrast, is a diversified day-trader who makes hundreds of small trades per month, thousands per year. Assume that Mr. A and Mrs. B have equally impressive track records - each generating an annualized net return of 20% over the last five years. Which of them would you entrust your hard-earned money with?
The most common answer is Mr. A. The precisely wrong answer! Why? Think about it. Mr. A has made so few trades that to assume that he's a skilled stock-picker would be like saying that someone who happened to flip heads 7 out of 10 times is a skilled coin-flipper. This flawed statistical logic completely ignores the significant role luck plays in probabilistic outcomes. Only a large sample size of trading decisions can reveal "true" skill, which is exactly what we get with Mrs. B. She's made thousands of trading decisions, so there's a lot more evidence that skill, not luck, is responsible for her success. To be clear, this doesn't mean that Mr. A is less skilled than Mrs. B - just that Mrs. B's track record is more statistically robust.
And this brings us to the ultimate question: How many stocks should you own to be sufficiently diversified? Should you just copy Mrs. B and buy hundreds of stocks? The short answer is no. Studies say the magic number is at least 20 to 30 stocks. I myself prefer to use the 1/N rule as it takes into account investors' subjective risk tolerances. The denominator "N" is the maximum percentage (of your equally-weighted portfolio) that you can afford to lose if one of your stocks goes bankrupt. For the typical investor, it's about 5% - the equivalent of owning 1 / 0.05 = 20 stocks. If you happened to be a more conservative investor, it might be 1% or even lower, in which case you should own at least 1 / 0.01 = 100 stocks.
To conclude, I wrote this article largely as a response to the numerous anti-diversification articles published here on Seeking Alpha in recent months. Click here and here to see couple of popular examples of what I mean. The basic gist of all these articles is, to paraphrase Warren Buffett, that "diversification is protection against ignorance . . . that those who know what they do concentrate their bets." This is only half true. Diversification is protection against ignorance - all of us are ignorant; some of us, unfortunately, don't realize it yet.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.