Spreading Your Bets
YOU MAY BE FAMILIAR with Peter Lynch. In the 1970s and ‘80s, he was one of the most visible figures in the investment world. As manager of Fidelity Magellan Fund, he achieved the best track record, by far, among his peers. He shared his wisdom in a series of popular books for individual investors.
Among the ideas for which Lynch is best known is the notion of “diworsification.” As its name suggests, Lynch argued that diversification simply for the sake of diversification isn’t always a good thing. If a portfolio is diversified in ways that detract from performance, it ends up being counterproductive.
This argument poses a challenge for individual investors. Especially this year, amid a rocky stock market, diversifying seems like the right thing to do, and that’s a broadly held view. Diversification is often referred to as the first rule of investing. So why do Lynch and others disagree, and what’s the best approach for individual investors?
The arguments for diversification are straightforward. Because investments rarely move in lockstep with each other, it’s helpful to have a mix of holdings. If share prices don’t all move up and down together, having a mix of stocks—especially in combination with a mix of bonds—can help dampen a portfolio’s price swings. Because of this dynamic, it’s almost a truism of personal finance that diversification simply makes sense.
This view has been broadly accepted in finance at least since the 1950s, when Harry Markowitz wrote his Ph.D. thesis on the topic. Markowitz’s paper is full of detailed formulas. But even before Markowitz, the intuition behind diversification was well understood. King Solomon offered this advice: “Invest in seven ventures or eight; you do not know what disaster may come.” Similarly, there’s the popular aphorism “don’t put all your eggs in one basket.”
But not everyone shares this view. In 1885, industrialist Andrew Carnegie gave a commencement address at a local college, and here’s what he said: “Don’t put all your eggs in one basket is all wrong.” He criticized those who scattered their investments “in this, or that, or the other, here, there and everywhere.” Scattered efforts, he felt, led to scattered results. Instead, Carnegie advised the audience, “Put all your eggs in one basket, then watch that basket very carefully.” In other speeches, Carnegie echoed this theme. “The great successes in life,” he said, “are made by concentration.”
Over the years, numerous investors have seized on this philosophy. Hedge fund manager Stanley Druckenmiller has cited this as his guiding principle. “All the great investors have made their fortunes by doing the opposite of diversifying,” he’s said, citing Warren Buffett and other fellow fund managers. According to Druckenmiller, Carl Icahn once put half his net worth into one stock—Apple—and made a fortune.
Warren Buffett has been maybe the most vocal proponent of this approach. “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
How can investors reconcile these viewpoints? On the one hand, diversification seems like the right thing to do, supported by both intuition and by decades of research. And yet some of the world’s greatest investors dismiss it with disdain.
The answer, I believe, is hiding in the details. Buffett says that diversification makes no sense, but he qualified that by adding “for those who know what they’re doing.” Similarly, Buffett’s late partner, Charlie Munger, once said, “The idea that a big portfolio of stocks is safer than a concentrated one is madness,” but added “assuming you know what you’re doing.”
In other words, holding an undiversified portfolio might make sense, but only if it’s your full-time job—that is, if you have the time to “watch that basket very carefully.” For ordinary people, Buffett and others agree that diversification makes good sense.
In fact, the reality is that even the greatest investors don’t always get it right. For years, Wells Fargo was one of Berkshire Hathaway’s largest holdings. But when a pattern of fraud came to light, the stock cratered, and Berkshire ultimately exited the investment. Stock-picking isn’t easy, even for these pros.
Risk of loss is one reason to avoid being too concentrated. But academic research has identified another reason to embrace diversification. As I’ve noted before, research by academic Hendrik Bessembinder has found, counterintuitively, that just a tiny fraction of stocks—4%—account for all of the stock market’s net gains relative to Treasury bills. The implication: If a portfolio isn’t sufficiently diversified, it runs the risk of excluding the next Apple or Nvidia, and that could be costly.
What does it mean to build a sufficiently diversified portfolio? For starters, it should be diversified along more than one dimension. Nearly every investor, in my view, should own a combination of stocks and bonds. In addition, holding cash can help carry a portfolio through years like 2022, when both stocks and bonds were down. Next, look to diversify within bonds and within stocks.
The market this year, in fact, has delivered a picture-perfect example of why diversification matters. For the past 15 years, investors have been punished for choosing virtually anything other than the S&P 500. But this year we've seen that reverse. International markets have outperformed. Meanwhile, within the U.S., value stocks have outperformed growth stocks like the “Magnificent Seven” that have led the market for years. Diversification, in short, can test investors’ patience. But as we’ve seen recently, it can pay off when we least expect it.
A note of caution: While diversification is important, it’s also important to diversify sensibly. In 401(k) plans, researchers have found that plan participants sometimes choose investments in ways that only look diversified. One study, for example, found that investors used a “1/N” approach to allocating their 401(k) funds, putting an equal amount into each fund regardless of fund type. Another study found that 401(k) participants exhibited “alphabeticity” bias. They diversified but tended to pick from the top of the list.
How can you avoid these pitfalls? A rule of thumb I suggest: Select investments in a way that covers all of the world’s major stock markets but with as little overlap as possible. For bonds, where exchange rate fluctuations can easily offset any gains, I recommend that investors stay closer to home. A sensible mix of domestic bonds, in my view, is perfectly sufficient.
Also keep in mind that diversification isn’t just about portfolio management. Several years ago, I suggested five other ways to diversify, and there are likely many more. It is, I believe, the golden rule of personal finance.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Among the ideas for which Lynch is best known is the notion of “diworsification.” As its name suggests, Lynch argued that diversification simply for the sake of diversification isn’t always a good thing. If a portfolio is diversified in ways that detract from performance, it ends up being counterproductive.
This argument poses a challenge for individual investors. Especially this year, amid a rocky stock market, diversifying seems like the right thing to do, and that’s a broadly held view. Diversification is often referred to as the first rule of investing. So why do Lynch and others disagree, and what’s the best approach for individual investors?
The arguments for diversification are straightforward. Because investments rarely move in lockstep with each other, it’s helpful to have a mix of holdings. If share prices don’t all move up and down together, having a mix of stocks—especially in combination with a mix of bonds—can help dampen a portfolio’s price swings. Because of this dynamic, it’s almost a truism of personal finance that diversification simply makes sense.
This view has been broadly accepted in finance at least since the 1950s, when Harry Markowitz wrote his Ph.D. thesis on the topic. Markowitz’s paper is full of detailed formulas. But even before Markowitz, the intuition behind diversification was well understood. King Solomon offered this advice: “Invest in seven ventures or eight; you do not know what disaster may come.” Similarly, there’s the popular aphorism “don’t put all your eggs in one basket.”
But not everyone shares this view. In 1885, industrialist Andrew Carnegie gave a commencement address at a local college, and here’s what he said: “Don’t put all your eggs in one basket is all wrong.” He criticized those who scattered their investments “in this, or that, or the other, here, there and everywhere.” Scattered efforts, he felt, led to scattered results. Instead, Carnegie advised the audience, “Put all your eggs in one basket, then watch that basket very carefully.” In other speeches, Carnegie echoed this theme. “The great successes in life,” he said, “are made by concentration.”
Over the years, numerous investors have seized on this philosophy. Hedge fund manager Stanley Druckenmiller has cited this as his guiding principle. “All the great investors have made their fortunes by doing the opposite of diversifying,” he’s said, citing Warren Buffett and other fellow fund managers. According to Druckenmiller, Carl Icahn once put half his net worth into one stock—Apple—and made a fortune.
Warren Buffett has been maybe the most vocal proponent of this approach. “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
How can investors reconcile these viewpoints? On the one hand, diversification seems like the right thing to do, supported by both intuition and by decades of research. And yet some of the world’s greatest investors dismiss it with disdain.
The answer, I believe, is hiding in the details. Buffett says that diversification makes no sense, but he qualified that by adding “for those who know what they’re doing.” Similarly, Buffett’s late partner, Charlie Munger, once said, “The idea that a big portfolio of stocks is safer than a concentrated one is madness,” but added “assuming you know what you’re doing.”
In other words, holding an undiversified portfolio might make sense, but only if it’s your full-time job—that is, if you have the time to “watch that basket very carefully.” For ordinary people, Buffett and others agree that diversification makes good sense.
In fact, the reality is that even the greatest investors don’t always get it right. For years, Wells Fargo was one of Berkshire Hathaway’s largest holdings. But when a pattern of fraud came to light, the stock cratered, and Berkshire ultimately exited the investment. Stock-picking isn’t easy, even for these pros.
Risk of loss is one reason to avoid being too concentrated. But academic research has identified another reason to embrace diversification. As I’ve noted before, research by academic Hendrik Bessembinder has found, counterintuitively, that just a tiny fraction of stocks—4%—account for all of the stock market’s net gains relative to Treasury bills. The implication: If a portfolio isn’t sufficiently diversified, it runs the risk of excluding the next Apple or Nvidia, and that could be costly.
What does it mean to build a sufficiently diversified portfolio? For starters, it should be diversified along more than one dimension. Nearly every investor, in my view, should own a combination of stocks and bonds. In addition, holding cash can help carry a portfolio through years like 2022, when both stocks and bonds were down. Next, look to diversify within bonds and within stocks.
The market this year, in fact, has delivered a picture-perfect example of why diversification matters. For the past 15 years, investors have been punished for choosing virtually anything other than the S&P 500. But this year we've seen that reverse. International markets have outperformed. Meanwhile, within the U.S., value stocks have outperformed growth stocks like the “Magnificent Seven” that have led the market for years. Diversification, in short, can test investors’ patience. But as we’ve seen recently, it can pay off when we least expect it.
A note of caution: While diversification is important, it’s also important to diversify sensibly. In 401(k) plans, researchers have found that plan participants sometimes choose investments in ways that only look diversified. One study, for example, found that investors used a “1/N” approach to allocating their 401(k) funds, putting an equal amount into each fund regardless of fund type. Another study found that 401(k) participants exhibited “alphabeticity” bias. They diversified but tended to pick from the top of the list.
How can you avoid these pitfalls? A rule of thumb I suggest: Select investments in a way that covers all of the world’s major stock markets but with as little overlap as possible. For bonds, where exchange rate fluctuations can easily offset any gains, I recommend that investors stay closer to home. A sensible mix of domestic bonds, in my view, is perfectly sufficient.
Also keep in mind that diversification isn’t just about portfolio management. Several years ago, I suggested five other ways to diversify, and there are likely many more. It is, I believe, the golden rule of personal finance.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.The post Spreading Your Bets appeared first on HumbleDollar.
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