There are certain investing concepts that never fail to illicit eye rolls. None more so than diversification.

Most investors accept guidance about diversification with a begrudging acknowledgement of its importance before largely ignoring the advice. A little like the assurance I give to my doctor on an annual basis that I will take better care of myself.

Before we explore the concept of diversification, consider this point: Most of the companies ever listed in Australia have suffered 100% losses.

Diversification checklist

This checklist is a useful starting point for investors who want to ensure their portfolio is diversified.

1. Start with the mix between growth and defensive assets.

The driver here will be the return needed to achieve your goals and the length of time until your goal which may limit your ability to withstand volatility.

2. Determine your asset class, geographic and sector exposures.

The wider you diversify the less exposed you are to the specific risks associated with a type of asset, country or sector.

3. Diversify at the holdings level to remove security specific risk

This can be easily done using ETFs of funds or by increasing the number of individual shares or bonds in a portfolio.   

The ‘anti-diversifiers’

A vocal minority of investors remain ardent anti-diversifiers. No amount of logic or reason will sway them from their belief.

Nobel Prize laureate Harry Markowitz called diversification the “only free lunch.” The anti-diversifiers don’t need a free lunch. They will build a concentrated portfolio full of ten-baggers. Lunch is on them. They will not suffer the folly of diluting returns on anything but their best ideas. And they have lots of good ideas. The anti-diversifiers are confident in their investing ability. Confident to the point where their investing outcomes are likely negatively impacted.

I will admit that I feel intellectually drawn to some of the arguments from the anti-diversifiers. Over time this appeal has dissipated as I’ve gained more experience as an investor and learned from the mistakes I’ve made.

So why do they think this way?

There is significant confusion about diversification

Diversification is often portrayed simplistically. We are told to not put all our eggs in one basket. Not exactly instructions to build a portfolio but easy enough to grasp. This analogy has the appeal of being conventional wisdom. The beauty of conventional wisdom is that it allows everyone to interpret it as they please. That works well in politics. Not so great in investing.

When pressed, many investors will say that a diversified portfolio contains assets that will go up in value when other assets go down in value. This fits well with a commonly held belief about shares and bonds. Many people think that when shares go up, bonds go down. And vice versa. The inconvenience of this view is that it is wrong. The latest example being 2022 when bonds went down significantly, and shares went down even more.

It is also not the point of diversification. Finding assets that are non-correlated – ones that move in opposite directions - is not the reason we diversify our portfolios. That is called hedging. And for most investors with a long time horizon and high return objectives hedging is the opposite of what you want to do. What most investors need is exposure to growth assets that will generate high long-term returns at the cost of short-term volatility.

Diversification is about achieving your goals

All of investing starts with goals. And diversification is no different. If I want to retire in 20 years and I need an 8% per annum return to get there I need to make sure my approach to diversification is helping me achieve my goal.

The best way to achieve my goal is to avoid a catastrophic loss that makes it impossible to reach my desired investing destination. Volatility is ok. That is the price we pay for the returns we earn. In 2008 the All Ordinaries Index experienced the largest one year drop in history. The index fell 40.40%. That is huge loss but was followed in 2009 with the index jumping 39.60%. For long-term investors that is not a catastrophic loss.

According to a Firstlinks article there have been 37,000 companies that have listed on Australian stock exchanges since the late 1800s. 33,500 of them have de-listed which rendered them worthless. 65% of the companies ever listed in Australia have suffered 100% losses. If you owned one of those companies and it made up a significant portion of your portfolio that 100% loss is likely catastrophic.

We diversify to reduce security specific risk in our portfolio. That is the risk that something goes wrong with a particular company we own. How much we diversify away that security specific risk is up to each investor. We could diversify it all away by owning an index fund that includes every share. We could diversify some of it by owning two companies. Each individual share you add to your portfolio will move your security specific risk along the spectrum from putting all your eggs in one basket and owning the entire market. Owning the whole market or every share available means you are just exposed to market risk. And you will get the market return. You are now a passive investor.

Investing in other asset classes is also all about achieving your goals. We can use bonds as an example. A bond has lower expected returns and lower volatility than a share. Adding bonds to your portfolio will lower your expected future returns and it will lower the volatility of your portfolio. You may want to lower your returns because you don’t need that high of a return to achieve your goals. You may want to lower the volatility of your portfolio because a short-term drop would mean you don’t achieve your goal.  

What if your goal is to get “rich”

Every time I talk about setting a goal as the foundation for becoming a successful investor I get challenged by somebody who tells me their goal is to get “rich”. Every single time. And I get it. We all want the most money possible. The problem is that having that nebulous goal provides no useful guidance on how to invest. It is like starting a journey without a destination. You tell yourself that you will know when you get there. But you don’t know where you are going. And you just putter around aimlessly. Makes for a good Hollywood wanderlust movie. Not such a good investing strategy.  

To get the most money possible the approach is simple. Find the share that will go up the most and put all your money in it. Seems easy enough. Please let me know if you happen to know what share is going to go up the most. I would really like to know.

A sophisticated version of the anti-diversifier argument uses the same logic. The basic premise is that if you diversify to a certain point you are starting to put securities in your portfolio that aren’t your best ideas. If your best ideas are all homeruns the returns from these lesser ideas will bring down the overall portfolio returns.

It is an interesting argument. And as I admitted earlier it had me enthralled when I first started investing. There are all sorts of quotes from hedge fund managers extolling this idea. They are all running concentrated portfolios. They are also all running hedge funds. If they significantly outperform, they become shockingly rich because of the performance fees. If they don’t outperform, they are just become moderately rich because of the management fees. And here is the other dirty little secret. The hedge fund manager may run a concentrated portfolio. But chances are the investors in that hedge fund have only put a portion of their portfolio in the fund. They are diversified.

Ultimately, I found the folly in this argument. I found it is bit like arguing you can save money on car insurance by just avoiding accidents. The reality is that investing isn’t that easy. The reality is that the future is unknowable. Companies are brought down by poor decisions that aren’t transparent to even the most diligent shareholders. They are brought down by new technology unimaginable a few years before. They are brought down by unexpected economic events and emerging rivals. They are brought down by well concealed fraud. These factors and countless others entail the security specific risk we are trying to diversify away.

Diversification is "for old people"

I hear this one a lot. A young investor will tell me that they understand diversification and plan to get to it once they are older and have more money. They assure me that since they are young, they can afford to take big risks.

It isn’t surprising that young investors have this attitude. It is consistent with the advice that young people are given in general – take risks now. Life advice is not good investing advice.

I’m currently 43. And $10k is worth less to me than it is to a 23-year-old. But it isn’t worth less because I make more money. It isn’t worth less because my portfolio is larger. It is worth less because the most valuable asset in investing is time. And the young have more time.

If that $10k is earmarked for retirement at 65 and you earn an 8% return it is worth just under $55k to me. It is worth $253k to the 23-year-old.

Being young isn’t an invitation to recklessly take on security specific risk.

Why I diversify

I don’t believe in diversification because everyone says it is the right thing to do. I’m not exactly James Dean but I do question authority. And I have a cause. My cause is achieving my goals. And I believe in diversification because I think it will help me achieve my goals.

I believe in diversification because I’m humble enough to know that there is a good chance my 20th best idea turns out to be better than my top idea. I believe in diversification because I’ve made mistake of having positions take up too much of my portfolio and have those companies implode.

I might ignore the advice during my next doctor’s visit. But I am not going to ignore the advice to build a diversified portfolio.