My last article was written on 12 June. It has been a very busy month for me. Finally, I can resume writing.
The most common piece of advice for investors is to diversify. “You may want around 10-30 stocks to be diversified”. The rationale behind this is to reduce the volatility of return so that you can have a better “risk-adjusted” return.
I have two thoughts on this.
Let’s say you know the future. You are 100% certain that stock one will outperform stock two to stock thirty in the next 5 years. Would you prefer to put all your money in stock one or “diversify” your money into 30 stocks? The value of diversification is the largest if you know nothing about the company you are investing in, and are therefore not confident about the company’s future. The greater the confidence, the smaller the value of diversification. I think confidence comes from research, and understanding of the industry. If you do not have the time, you are better off buying the most diversified asset, i.e. index funds, instead of picking 30 individual stocks by yourself. So, the risk is due to a lack of information.
My second thought is related to the correlation of stock performance. For the diversification strategy to work, you need to find uncorrelated stocks. If stock A and stock B are 100% correlated, you will double your profit and loss. If stock A and B are -100% correlated, you will always make 0 profit. But ironically, the correlation between stocks is high when we need the power of diversification the most. During a financial crisis, most stocks fall. Bond price falls. Property price falls. Diversification will not save us.
So, to diversify or not diversify? If you participate in the stock selection game instead of buying index funds, diversifying means you are not confident in your pick. Probably, you have to study more and be more certain. Owning 30-something stocks or even 20 stocks looks like betting at random. If you don’t have the time, buy the most diversified index funds.