Others   

Focused Investing vs diversification

Good article. However, today's environment isn't really rational. Even Warren Buffet's firm has lost some of its shine.  

 

Focus investing is a method of investing heavily into only a handful of stocks (8 to 10) to gain sufficient diversification and yet prevents overdiversification. Sometimes, the number of stocks invested may be even less than 8 (Warren Buffett has most of his capital in only a handful of stocks of excellent businesses). On the contrary, diversification requires many stocks to be bought (more than 10).

Focus investing is a highly profitable way of investing since an investor only holds a handful of stocks and if these few stocks all perform, the investor can make large returns. This method of investing requires putting all eggs into only a few baskets. The arguement against putting all eggs into only a few baskets is that should the investor makes mistake in stock selection, the potential for large loss is also present since his money is held only in a few stocks.

Diversification has its merits in putting all eggs into many baskets. Even if some stocks underperform, other stocks may still perform. Therefore, the potential for huge loss is reduced. However, the potential for phenomenal returns is also reduced as well since it is unlikely that all the numerous stocks on hold should gain large returns at the same time.

Question:- Should one follow a focused investing method or diversification method of investing? Traditionally, people always advise against putting all eggs into one basket as when the basket breaks, all eggs will be lost. This is definitely true. However, it does not make sense also to overdiversify and get average returns on one's investments.

Discussion:- Focused investing is a superior way of investing, but it is only suitable for some and not all investors. It requires the investor to have very good financial knowledge in evaluating and selecting the few excellent businesses that the investor has decided to invest in. The investor have to do a very good job at assessing and selecting businesses to invest in. Any wrong assessment on the part of the investor, he will have to bear the consequences of a large loss since his money is only held in a few businesses. However, if the investor is right about his assessment, his returns will be very sweet since he would have considered only investing in the rare few most excellent businesses. Thus, focused investing method requires high amount of financial and investing knowledge and rigor to execute well, and yet has a higher rate of return than normal diversification can give.

Diversification is suitable for most investors since most investors may not have the high amount of knowledge and rigor in assessing businesses. If that's the case, just buying many different stocks or types of investment (e.g. equities, unit trusts, bonds, fixed deposits) will allow the investor to make average returns at lower risk since diversification is like buying an index (basketful of many stocks). Some will underperform while others perform. An investor can be almost guaranteed of average returns in the long term which is still reasonable considered the low risk of diversification.

On a parting note, invest only in what one understand. If one is not willing to put in the extra effort to better one's investing knowledge, then diversification makes good investment sense by buying into many different stocks or types of investment. However, one should still understand the things one is investing in (e.g. consider the madoff scandal, lehman brothers' minibonds that have resulted in investors losing their capital). I mean no offence in raising such examples. These examples are just to caution one about the need to understand what one is investing his hard-earned money into. Afterall, every investor hopes to acheive a personal financial goal and no investor wants to lose his invested capital.