This video is a complete 180 from one of the very first videos I did on my channel, where
I talked about all of the reasons to invest in index funds.
Index funds maximize your diversification by investing into hundreds or thousands of
different stocks at once.
This is a safe and proven strategy that returns about 10% a year, on average.
But if these returns are so predictable over the long-term, why do some of the wealthiest
investors speak so strongly against diversification?
The simple answer is that diversification won’t
make you rich.
They say that a concentrated portfolio builds wealth, while a diversified portfolio preserves
it.
So in this video, I want to explore the idea of diversification from this perspective.
First, we’ll talk a little more on why diversification is one of the worst ways to get rich through
investing.
Then we’ll talk about some of the benefits of avoiding diversification, including one
of my favorite reasons for doing so, which is the idea of a high conviction stock.
And so you guys don’t tear me apart in the comments, we’ll also cover when you may
still want to seek diversification despite its negative impact on your overall returns.
Finally, if you’re interested in sticking around, I’ll share how I’m adjusting my
diversification strategies in my portfolios.
So let’s get into it.
The argument against diversification is pretty easy to understand.
The main reason that diversification won’t make you rich is because it spreads your investments
too thin.
As a result, when one of your investments produces substantial returns, you have too
little money invested into it to make a significant impact in your overall portfolio.
For example, if you concentrated a $10,000 investment into a stock that produced a 100%
return, you would have doubled your money to $20,000.
But now, imagine you made a $10,000 investment into a well-diversified portfolio.
This could be something like the S&P500 or a similar total market index fund.
For this example, we’re going to use the Russell 3000 index, which is an index that
tracks the 3,000 largest U.S stocks by market cap.
Over the last 40 years, this index has produced an average annual return of 11.5%, which would’ve
turned your $10,000 investment into just $11,150.
And that’s not bad by any means, but when you look at how each of the underlying stocks
contribute to this return, it may change your mind.
A study by Crittenden and Wilcox called “The Capitalism Distribution” analyzed the Russell
3000 index from 1983 to 2006.
This study found that out of all stocks in the market, 39% of stocks lost money.
64% of these stocks underperformed the index, which means they produced less than 11.5%
returns on an annualized basis.
On the flip side, 36% of stocks outperformed the Russell 3000 over this period.
That’s a fairly large pool of stocks that would’ve given investors an opportunity
to outperform the index.
But when you invest into this index or a similarly diversified portfolio, you’re actually investing
more into losing stocks than you are winning stocks.
The study further finds that 25% of stocks contributed to the entire returns of the market.
So when everything averages out, the returns from 25% of stocks are enough to produce positive
returns that make up for all of the losses in the market.
And that’s part of the appeal of diversification, because it nearly guarantees a positive outcome.
But, it also comes with the cost of holding a lot of losing investments that are significantly
lowering your potential returns.
In a perfect world, if you are able to identify the stocks that can outperform these indexes
and produce those market-leading returns, then your portfolio growth can be huge.
Of course as we know, this is very difficult in practice.
There are tons of studies that show even professional money managers and active funds of all kinds
struggle to beat the market over the long-term, and even some that suggest we’re no better
at picking stocks than a blindfolded monkey.
However, because the idea of diversification are so drilled into the investment world,
I think few people actually stray from its principles.
Warren Buffett, who has spoken against diversification, has nearly 50 stocks in the Berkshire Hathaway
portfolio.
According to this study on fund holdings by Shawky and Smith, fund managers tend to hold
around 40 to 120 stocks.
Even studies that tested monkey’s abilities to pick stocks gave them a portfolio of 30
stocks.
And although the exact range will vary depending on who you ask, most research shows that you
get the majority of the effects of diversification when you hold any more 30 stocks.
So overall, I think there are few places to look for the long-term results of a truly
concentrated portfolio.
And I think approaching the territory of 30, 40 or 50 stocks might get into the range of
over-diversification where you’re limiting your potential returns.
And when you think about all of the benefits of a non-diversified strategy, I think there
are several strong reasons to consider it.
First is the fact that it gives you the time to learn every aspect of a business.
When you’re holding more than 30 or so stocks, the odds are pretty low that you know each
and every one of those businesses very thoroughly.
It would take a ton of energy to keep up with everything going on in each of those businesses
or industries, which would limit your ability to make educated investment or trade decisions
with each one.
With a concentrated portfolio, you can focus your efforts on just a handful of businesses
that you understand on a very deep level.
And while there are plenty of reasons to avoid timing the market, monitoring stocks for months
or years at a time can help you make timely purchases of your favorite stocks.
As someone who has been involved quite heavily with SPACs lately, I’ve seen a lot of volatility
in my favorite holdings.
I’ve been able to trade around this volatility to lower my cost basis and take profits where
I wouldn’t feel comfortable doing so if I hadn’t been keeping a close eye on these
holdings.
And that’s something I wouldn’t be able to do if I were watching dozens or more stocks
at a time.
Again, just having the time and energy to devote to a small number of stocks can pay
off by making you more confident in your decisions.
And this leads into one of my biggest reasons to avoid diversification, which is the idea
of having high conviction stocks.
Having high conviction in a stock means that you are fully convinced of its long-term potential
as a company, which should mean you’re equally convinced of future stock returns.
For me, conviction stocks start with research.
I want to dig into a business and understand every part of it.
I like to look for potential catalysts, a wide moat to separate from the competition
and profitability.
When considering this kind of information, I’m usually able to identify a price I’m
comfortable buying the stock at, as well as a price range I could see the stock reaching
in the future.
And this is something I have the ability to do by focusing on a few stocks instead of
a larger portfolio.
Once I have all of these pieces, investing in the stock is something I can do with complete
confidence.
Then, everyday I check the markets, I can quickly decide whether I want to buy more,
take profits or keep holding.
Volatility no longer matters for high conviction stocks, because I have already decided the
actions I want to take at different price levels.
I won’t get shaken by downard price movement because I’m confident in my research and
the underlying stock.
Having this foundation of conviction with a stock, in my opinion, can be one of the
biggest advantages for navigating an investment.
So at the end of the day, when I identify a high conviction stock, it’s something
that I would trade a diversified portfolio for anyday.
With this conviction, assuming you have higher risk tolerance, it’s easy to justify a lack
of diversification in your portfolio so that you can achieve the higher returns that come
with it.
Of course, diversification might not be a bad thing for all investors.
As we mentioned, it won’t be the fastest path to building wealth, but it does have
many applications.
Warren Buffet says that diversification protects against ignorance, and this is one of the
first reasons to diversify.
For investors who don’t understand the stock market, diversifying is the best way to participate
and earn returns on your money without high levels of risk.
It’s thanks to diversification and things like index funds that anybody can participate
in the stock market and enjoy long-term growth.
Similarly, diversification can be a smart option for investors with a low risk tolerance.
Just like diversification limits your returns and upside potential, it can also reduce the
threat of downward movements.
There are risks associated with any investment, but with more diversification, you reduce
the impact of these risks and the volatility of your portfolio.
Someone who prefers a smoother ride or wants to minimize their potential losses could stick
to a diversified strategy.
Last, for investors who don’t want to put in the time to research and select stocks,
diversification is an easy option.
You can invest in an index fund after checking a few simple characteristics and you’re
good to go.
And there’s nothing wrong with securing the returns of the market and letting compound
interest do its thing over the course of your lifetime.
But, for investors like myself who want to build wealth faster, have higher risk tolerance
and are interested in researching and investing in individual stocks, diversification could
be the worst possible decision.
So as someone with a more aggressive strategy, I’m becoming more comfortable with having
a concentrated portfolio rather than a diversified one.
Over time, I want to build up a small portfolio of high conviction stocks that I can invest
into heavily in the coming years.
Admittedly, I only have one high conviction stock in my portfolio right now, and that’s
ticker $STPK, a SPAC set to merge with a smart energy storage business called Stem.
It makes up nearly 50% of my investment portfolio, which I’m entirely comfortable with because
of my high conviction in the business and the value of the stock.
But I hope to get to a point where I have 5 to 10 high conviction stocks that make up
80 to 90% of my portfolio.
This is my standard taxable portfolio that I am investing in purely with an aggressive
growth strategy.
As I said, I’m not too concerned with volatility or risk, and that’s because I still invest
into my Roth IRA as my safer retirement plan.
I still use standard index fund and diversification strategies in this account so that I can expect
my Roth IRA to produce more than enough for retirement.
With this sort of safety net of an investment account, I am more comfortable using risky
or aggressive strategies in my standard account, where I can potentially lower my retirement
age by a few years if I’m successful.
So from here on out, I’m going to stop pressuring myself to diversify out of stocks I really
like.
It also helps that I’m young and still have a fairly small portfolio, so using $20,000
for a higher-risk strategy won’t destroy me in the long run.
As the saying goes, once I’m able to build wealth with a concentrated strategy, I’ll
shift to a more diversified strategy to preserve that wealth.
But I’d love to hear your thoughts, so leave me a comment and let me know how you approach
diversification in your portfolio!
Thanks for watching and I’ll see you in the next video.