Is Diversification a Blessing or a Curse?

The Smart Investor03-25

[ Share Facebook Twitter LinkedIn Email WhatsApp Diversification is either good for you or bad for you, depending on who you ask. Warren Buffett, the legendary investor and businessman, ...

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Others think it’s a waste of time. 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Lynch was famous for holding up to 1,400 stocks in his portfolio.\nHere’s the surprise: they both achieved remarkable success, despite their opposing views.\nSo, what does this mean for you, the investor? Should you diversify, or not?\nDiversification is not a number\nFor starters, diversification is not just about the number of stocks you own. \nBuying a fund which tracks Singapore’s Straits Times Index (SGX: ^STI), for instance, will give you a stake in 30 stocks.   \nHowever, for every S$1,000 invested, around S$454 will go to Singapore’s three banks, namely DBS Group (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39) or OCBC and United Overseas Bank (SGX: U11) or UOB.  \nAnother S$60 or so will be invested in Singapore’s largest telco, Singapore Telecommunication Limited (SGX: Z74) or Singtel.  \nIn effect, more than half your money will be in these four stocks alone. \nHence, buying Singapore’s STI will not help you to diversify as much as you think. \nIn contrast, buying a single share of Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A) would net you a cornucopia of different companies. \nThere is a wide collection of billion-dollar businesses from the insurance, railroad (BNSF), and industrial (Lubrizol) sectors alongside smaller businesses such as See’s Candies (snacks), Brooks (running shoes) and Fruit of the Loom (undergarments). \nAnd that’s not all. \nBerkshire Hathaway also owns portfolio of stocks with huge positions in Apple (NASDAQ: AAPL) worth about US$155 billion, Bank of America (NYSE: BAC) at US$36.8 billion, American Express (NYSE: AXP) at almost US$34 billion and Coca-Cola (NYSE: KO) at nearly US$24 billion, to name a few.   \nArguably, this single stock, Berkshire Hathaway, is at least as diversified, if not more, compared to a 30-stock index. \nThat said, business diversity does not guarantee safety. \nDiversification at different levels\nConvention wisdom says that diversification is about buying different businesses from unrelated industries or geographies. \nThis line of thinking can be useful, but it is not enough. \nIn the case of Berkshire Hathaway, Buffett makes most of the capital allocation decisions. He’s been great at it for a long time, but he’s 93 years old today. \nHe won’t be around forever.\nSo, even though Buffett’s holding company has a diverse range of businesses, he still plays a big part in generating superior returns for shareholders.\nWhen he passes on, it’s hard to imagine anyone else doing it as well as he did.\nTo be sure, concentration risk is not limited to the management level alone; it can show up in different parts of a business too. \nSize alone does not guarantee diversification.\nLook at Apple, the iPhone maker. \nThe company is worth over US$2.6 trillion dollars but it relies on one contract manufacturer, Foxconn Technology (TSX: 2359), to make most of its products. And only one company, TSMC (NYSE: TSM), manufactures chips for the iPhone. \nIn turn, both TSMC and Foxconn rely on Apple for a significant part of their revenue.  \nThe examples above illustrate how concentration risks can form at different levels of a business, including suppliers and customers.\nDiversifying for the right reasons \nAs we delve deeper into diversification, we should not lose sight of its goal: to reduce risk. \nThis is where buying businesses from unrelated industries or geographies can go wrong. In fact, investors who diversify into areas where they lack expertise are taking more risk, not less. \nIt makes little sense to do so, says Lynch. \nHow well you know your stocks matters more than how many sectors or regions you spread your money across.\nMy preference? \nI agree with Lynch. Diversify only if you want to boost your chances of finding more winning stocks in your portfolio.\nHere is a point you shouldn’t miss: you should always be looking to learn more about new businesses and industries. \nAs you become more knowledgeable, you can grow your portfolio with more stocks you know well, but without exceeding your limits.\nRemaining humble is key. \nKnowing the limits of your knowledge in any new area is how you keep yourself in check. As author Carl Richards once said: risk is what’s left when you think you’ve thought of everything. \nDiversifying over time\nNever rush into investing in a new business or industry. Take your time to learn.\nHere’s a simple rule of thumb to help you.\nIf you’ve been following a new company for a year, invest no more than one percent of your portfolio into the stock. If it’s five years, then up to five percent.\nYou can adjust the percentage to fit your risk appetite.\nThe point of this strategy is to have a reference point where you can match your risk level with your knowledge level. \nLet me say it again: be humble with new stocks. \nYou never know everything in the business world. Things can change over time as industries and players grow and adapt.\nThis is where simplicity works best: a rule of thumb to keep yourself in check.  \nFinally, investing over time helps to spread your risk over years. \nDon’t worry about starting small in a stock. A winning stock is only known in hindsight. \nHere’s the point most people miss: if a stock is destined to be a winner, the stock price rise will happen over years, if not decades. \nAnd guess what? \nYou will have plenty of time to add to that winning stock.  \nGet Smart: Concentration as an outcome\nHere’s the final conundrum: the mark of a successful portfolio is a concentrated portfolio.\nBut how can that be? \nLet’s say you invested $1,000 each into 10 stocks. \nEach stock will make up a tenth of this $10,000 portfolio.  \nAfter five years, the first one skyrockets, increasing by 10 times and is worth $10,000, while the last one goes to zero. The other eight stocks stay the same at $1,000. \nDo the math and you’ll end up with $18,000 in total. \nThe big difference is, the winning stock will comprise more than 55 per cent of the five-year old portfolio. \nWhat more, because of its size, if the best-performing stock continues to do well, it will drive most of your returns in the future. The worst-performing stock, which went to zero, will fade away and have no further impact on your portfolio. \nThat’s a pretty good outcome, isn’t it? \nAs you diversify to find more winners, the best of them will naturally rise to the top — thereby concentrating your portfolio in the right set of winning stocks. \nThat’s more than any investor can wish for. \nThe best gift a responsible parent can give their child is a secure, comfortable financial future. And we found that dividend investing is one of the easiest and effortless methods to do it. Our latest FREE report reveals how you can do it, plus the 3 SGX stocks you can buy today to start future-proofing your child’s financial future. Click HERE to grab a copy of the guide.\nDisclosure: Chin Hui Leong owns shares of Apple, Berkshire Hathaway, DBS Group, OCBC and UOB.\n\n\n\n]","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":1,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2422783585"}