Preface
The Risk Management Guru (RMG) blog was founded in October 2015 with a very clear sense of purpose: to become the go-to blog for the best articles about Risk Management. Almost 5 years on and we are proud of the footprint we have created so far, with a special emphasis on our most read articles.
The success of this blog is due to three main pillars: our growing readership base, who spread the word of mouth, the quality of our content, which is something we strive daily, and, most notably, our contributors (i.e. our gurus). Without you, this adventure would not be possible nor would the Risk Management Blog have its unique personality.
We receive proposals to publish content from new potential contributors on a weekly basis. It is not rare for us to reject articles that we feel do not have the same type of message that we want to share with our readers (many are just looking for backlinks). All our contributors are seasoned, well rounded, Risk Management professionals or working in the Financial Services industry.
This week we received something entirely different, that really caught our attention: an international grade 11 student requested for his essay to be published. After reading it through, we’ve found that this young man, who is starting his journey in the world of Finance, does have the personality and apparent acumen that is needed for the Finance industry.
We hope you enjoy Ricardo’s essay as much as we did. Moreover, we really do look forward for more articles coming from Ricardo.
Why portfolio diversification is for the ignorant investor
It is often said that one should place their eggs in multiple baskets in order to spread out risk: if one basket is dropped one will not lose all their eggs. This is often mentioned in the world of investing where clients trust their advisors to spread their money over a hundred stock funds among other asset classes such as bonds and commodities to protect their customers against risk. That does define the concept of diversification but not the one of successful investing. By investing capital in over two hundred stocks one will at most break even with the market’s average returns, about 7 to 8 % not considering inflation. If an investor wants to make average returns, no doubt diversification is a sound strategy but nobody has ever gotten wealthy like this. Anyone can do average in 8th-grade. Successful investors like Warren Buffet, Charlie Munger and George Soros accumulated a fortune by concentrating most of their capital in only a handful of businesses they had a thorough understanding of. Investors that concentrate their holdings outperform the over-diversified ones due to an understanding that diversification is unnecessary when one knows how to value a business, that spreading money over hundreds of companies is foolish since one cannot keep up with all of them, and the poor quality of many of the available diversification vehicles in the market.
First, investors that have acquired the necessary knowledge to analyze a business, that being aware of the company’s financial position by analyzing its statements of balance sheet, income, and cash flows, have recognized its competitive advantage and are happy with the management and their decisions have the skills to recognize which businesses to invest in because they can identify the most valuable ones. In contrast, unknowledgeable equity buyers struggle to know which companies to invest so they often spread capital across overly diversified index funds, which are baskets of hundreds of stocks, hoping to avoid risk. However, “ risk comes from not knowing what you’re doing” as Warren Buffet once said. This is evident when you compare the returns of Berkshire Hathaway, a company managed by Buffet that has over 70% of its capital in a handful of stocks including Bank of America, Apple, Coca- Cola, and Wells Fargo to a popular index like the S&P 500 that tracks the largest five hundred corporations in the United States. From 1965 to 2017 Berkshire produced a yearly average rate of return of 20.9% whereas the S&P stood well below at only 9.9%, which is a huge compounded difference for fifty-two years. This demonstrates that disciplined investors such as the managers of Berkshire understand that risk can always be reduced when one knows how to study companies and make wise and rational picks. Those outperform the ones of the uneducated investors that massively diversify across the indexes and other instruments. Therefore it is a better strategy for one to accumulate knowledge and invest in a couple of fantastic businesses than blindly investing a small amount in one hundred stocks which they have no understanding of, hoping to protect themselves against “risk”, which in reality it is only protecting them against their own ignorance as Buffet once said in a shareholder meeting.
Another reason why diversification is a poor and overrated investment strategy is that it is considered impossible for the average person working nine to five to be on top of hundreds of investment securities. A person can simply not have a deep understanding of Apple and Coca Cola, German car manufacturers, Chinese retailers, and Jamaican corporate bonds all at the same time. This was made clear by Bernard Baruch, a respected American investor, and economic advisor to President Franklin D. Roosevelt, when asked on diversification he said: “While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues.” In other words, it is much better to focus on knowing a few securities well than many poorly because in order to invest successfully it is crucial to understand the investment in question for the goal of generating sustainable long term gains. Thus, the diversification strategy is one that keeps the investor unfocused on his holdings since there are so many that he cannot be on top of them all, whereas the strategy used by Gurus, of focusing deeply on a few issues has provided more safety and better returns in the long run.
Lastly, Investors that seek to diversify often fall into the mutual fund trap, generating mediocre returns often offset by inflation rates. Mutual funds are index funds that are actively run by managers. Not only do these investment vehicles often buy poor companies, but they also charge high fees, averaging 2.1% of the principal invested in Canada. According to an article from the Financial Post, the primary focus of mutual funds is not to make their clients money but to charge them more fees. They achieve this by buying more assets, resulting in more diversification. The returns of these funds are often poor, and even underperform the ones of low-cost index funds. In the last fifteen years in the United States, 92% of mutual funds underperformed market returns, often classified as average. In Canada, CIBC’S balanced fund generated a mediocre 4.8% yearly return in the last ten years. Investors are much better if they did their own research and concentrated their funds in companies they understood while benefiting from commission-free platforms available nowadays. Therefore Individuals should pass on the diversification strategy due to the poor quality of many of the diversification instruments such as mutual funds whose main goal is not helping their clients retire. Instead, investors should concentrate their funds in businesses they love and understand and thoroughly analyzed.
In conclusion, one looking to accumulate wealth and retire early by the means of investments securities should not diversify but learn from the Buffets and Mungers of the world, concentrate their portfolios into no more than a handful of businesses they truly understand, study and admire. This strategy has worked for decades and will continue to outperform diversified investors challenged by their lack of business knowledge. This forces them to diversify, protect their capital against “risk” by investing in a wide range of securities that are impossible to be on top of at once and often fall into funds that are simply eating their capital with expensive commissions.
Works Cited
Graham, Benjamin. The Intelligent Investor. Harper, 2006.
Town, Phil, and Phil Town. “Why Diversification Is for the Ignorant: Phil Town.” Rule One Investing, 24 May 2017,
https://www.ruleoneinvesting.com/blog/how-to-invest/why-diversification-is-for-the-ignorant/.
Kaufman, Karl. “Here’s Why Warren Buffett And Other Great Investors Don’t Diversify.” Forbes, Forbes Magazine, 25 July 2018,
Financial Post. “Why Canadian Mutual Funds Underperform.” Financial Post, 7 Dec. 2013, https://business.financialpost.com/investing/why-canadian-mutual-funds-underperform-2.
BobPisani. “Active Fund Managers Trail the S&P 500 for the Ninth Year in a Row in Triumph for Indexing.” CNBC, CNBC, 15 Mar. 2019, https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html.
