Diversification is commonly stated as “not putting all your eggs in one basket”. That is true, but there’s more to it than that. Here’s a short video that explains the concept in more depth. Diversification benefits investors by protecting your portfolio more.
If you also rebalance your portfolio on an automated basis, it's better still, because you’re returns are likely to increase too.
‘Diworsification’ is a play on words stating that diversifying is worse for an investor. This is an opposing view that says holding more concentrated positions is better. This means an investor is taking more of a punt that they know what will do well, and invest more money into it. To their credit, if they make that investment decision and call it right, a concentrated investment CAN lead to higher returns, however, notice the key word is “can”. “Can” is not the same as “does”. The odds are quite low that any one investment WILL do better than an index or a ‘basket’ of investments. Typically, the smartest investment decision is the one that has the highest odds of growing someone’s money (or protecting it). That’s what diversification does: It takes the extreme outcomes and smushes them into the middle where things become more likely to work out well.
Think of a floor and ceiling - The bottom represents awful investment returns and the top is great returns.
The image to the right shows how $100 can grow 100x, however you can also lose everything. The way our brains are wired as humans, we see the number at the top and get excited, and don’t process the odds that an investment grows that much is effectively nil. We also overlook the downside which is losing everything, which is more likely than the money growing 100x.
To the left is the same idea but with some diversification. You’ll notice the top and bottom are closer to the middle point now. The upside is bigger than the downside but it’s also MUCH more likely to grow. That’s the most important part!
When people talk about ‘diworsification’ they are falling into a classic trap of human psychology. It’s called “Denominator Blindness” and it just means we overlook the odds
of something happening. They see the potential, which is the top number, that the investment could grow to, and they stop behaving rationally. Lottery tickets sell because of this same tendency. These people see diversification as taking away their
chances of winning big, and therefore see it as worse than giving it a go. For every winner you hear about that invested in Company X and turned $10k into $5.7M, there are about 1,000 other people that lost. A few would’ve lost everything, some would’ve lost a lot, and a huge chunk would have lost at least a
little bit. So concentrating investments and avoiding diversification means you are moving away from smart investing and moving more towards gambling.
This is how Carl Richards expresses his thoughts:
So here’s what it comes down to:
Concentration gives you a small chance of quick-big money. It also increases your odds of losing some or all of your investment.
Diversification does decrease your odds of amassing an overnight fortune, however, it increases your odds of amassing a fortune over time.
Written by: Cam Irvine