Diversification or Diworsification?

I forget where I first heard the quote, but several years ago, I was watching a video with Charlie Munger and Warren Buffet where one of them said something to the effect that “Diversification is for people that don’t know what they’re doing”. It was a typically astute observation from the duo, and it made me realise that many so called ‘investors’ are actually closer to gamblers and are using diversification as an attempted defence against bets going wrong.

At its most basic, diversification within a portfolio refers to holding assets that respond to market conditions in uncorrelated ways and holding lots of them. The main driver behind this is that these assets are unlikely to all suffer from a simultaneous collapse in value or revenue producing potential, thus lowering portfolio risk.

In practice however, there is a fine line to be walking between diversification and what many refer to as diworsification, which is the process of accumulating many different assets that all work against each other (when one goes up, another goes down and your portfolio remains static). At a certain point, spreading your investments over too many baskets dilutes your ability to generate consistently above market returns (depending on what you define as ‘the market’). For example, if you seek to grow you net worth by 15% a year after inflation, there are only so many properties, commodities and shares which will enable you to do so – the vast majority will fall significantly short of this target in many years and force you into riskier and riskier opportunities in order to counterbalance their shortfall.

I have constructed my portfolio over many years and spend a good period of time optimising each ‘section’ to work as part of the whole. Shares are a wonderful asset to hold, but I diversify across sectors and keep a close eye on industry news to ensure I don’t hold positions into terminal collapse. In addition to this, I hold property, private placements, cash, foreign holdings and am currently researching commodities.

At the same time, I constantly review performance to determine which areas of my portfolio are dragging on overall returns. If I cannot identify a good reason for this underperformance, then I am likely to sell on the asset to optimise overall returns. This has the added benefit of keeping my portfolio to a manageable size – I know all of my holdings and funds, understand my properties, and keep in semi-regular contact with the companies I have invested with to understand their latest issues and successes. At any one time, I might be researching between five to ten opportunities and considering selling up to another five.

As such, one of the most important issues I face is understanding how and why to sell an asset – if I make a £1000 investment and watch it climb to £5000 before declining back to £1000, that’s as bad to me as investing £5000 and getting the same result. When I hold something, I need to understand its performance relative to the rest of my portfolio. If I bought it on an undervalued basis, when do I consider it fairly valued? Do the fundamentals of the asset still support its current valuation? Has it performed in a consistent manner to my expectations and if not, why do I think that is likely to change?

Ultimately, when diversifying, I only want to hold what I perceive to be the top 10-20% of opportunities available to me in the current market. Anything outside of this is simply adding research and holding costs, and increasing the risk of a major investment issue occurring. After all, what is easier to get safely from the henhouse to the kitchen; a single egg, or 500 of them?