Concentrated Investing Vs Diversification
Is diversification a bad thing when it comes to investing? Are better off picking a 'winning' investment?
Don’t put all your eggs in one basket. We hear this all the time, but it’s not clear enough what it does mean. If you have 2 baskets, is that enough? What about 20? What about 2000?
Today we’re going to look at why holding all your eggs in one basket is risky and what it can mean for investors.
Concentration means you are focused or having too much reliance on a small number of things. Concentration is the opposite of diversification. There are a couple of potential upsides to having concentration, but many downsides and most people have far more concentration and less diversification than they think. Sometimes people will buy 5 stocks thinking that’s enough, but come to find out, they just bought Netflix, Google, Apple, Amazon and Facebook, which are all tech companies based out of the US, so they aren’t really diversified at all. The same goes for housing, where owning multiple rental properties in one country, still means you are relying entirely one a single countries property market, and as we have seen many times, things can go wrong.
To be clear, When you hear people say they lost all their money in the stock market, what really happened was they didn’t diversify enough and just invested in a handful of companies. That’s why they lost everything. The problem is, what gets reported to the press is ‘people are losing all their money’ because it doesn’t sell headlines as well to say ‘people that made concentrated and uninformed investment decisions had a bad outcome, that was statistically likely to happen anyway. Diversified and patient investors that don’t speculate will have probability on their side”
Gambling is the perfect example of concentration. You make a bet and it can pay off handsomely, or you can lose it all. That’s how it goes. The financial graveyard of history is filled with concentrated investors. Here are 2 more examples:
· In 2008, Lehman Brothers filed for bankruptcy because of their extensive exposure to mortgage-backed securities filled with subprime loans.
· Silicon Valley Bank
Here’s how it works: Imagine a multiverse, where there’s an infinite number of possibilities of what could happen. In one version of the universe things are great, and in another things are awful. A single investment in a company that is named Potential Future Inc or PFI for short. Well, PFI’s stock/ shares/ or value has a certain chance of going up or down in any one year. The problem is, because it’s only 1 thing, it can go way up or way down in any given year. So starting with 2023, $1000 invested might turn into $10,000 which sounds great, or it might turn into $30 which is…less great. That’s just 1 year though.
Let’s move forward to 2024, the same rule still applies. In the Good-iverse, that initial $1000 investment could have turned gone up to $10,000 and then to $200,000, or in the other universe, maybe the less fortunate version saw the $30 investment come back up to $75, or down more to $15.
2025 is the same again but it’s possible in the great universe of possibilities maybe the investment drops from $200k down to $35k and the bad universe goes to $0 with bankruptcy or recovers some back to $500. And so on. You can see that the range of outcomes is entirely unknowable and really really different. This is how investing in a single thing works. It’s not at all reliable.
But history tells us that the odds are twice as great that you’ll go broke on a single day compared to hitting it big. So just like the Hunger Games, the odds really aren’t in your favour. Why would someone want to play that game where you are twice as likely to lose, especially when losses are psychologically about 2.5x as painful as the joy is from gains. This means you would have to gain $100 in order to balance out a loss of $40. This was uncovered by 2 Israeli psychologists shown here, who’s work turned into this book, if you interested in learning more.
Basically, Concentration is asking for stress and anxiety.
So that example shows how a single investment might do, whereas a diversified investment has so many components, it will likely never increase 100x in a year, but it also won’t likely go to $0. That’s how diversification works, it’s a way to hedge your bets which is another way of saying, lowering your risk. Investors are better protected and because they are diversified, it’s more likely that they will achieve return within a smaller range. The outcome is more predictable and reliable. So going back to the drawing board here, we’ll compare the range of outcomes for investing a diversified portfolio vs concentrated.
So what are our Take aways?
The odds are less than 1 in 4 (or 25% chance) that someone can pick a winning investment. Sometimes the odds are closer to 1%.
Concentration can work, but it’s important to understand that ‘can’ doesn’t mean ‘will’. It’s more likely it does not work out.
Diversification allows for more consistent investment outcomes. So if you want to plan your future, diversification is necessary.
The more diversified, the better. The more concentrated, the more risky. A few hundred investments is considered diversified to some, but our opinion is based on the evidence, that several thousand investments is true diversification.
We’ll leave you with this quote: “While concentration is the fastest way to impossibly high wealth, it’s also the fast train to low levels of wealth.”
Concentrated Investing Vs Diversification