Do we need diversification?
Some people ask me: if I believe that Tesla is a good company and will go up in the long run, why should I care about risk and diversify my portfolio? So this article briefly explains why we need to hold a diversified portfolio (or not).
This video titled “Why Buffett, Cuban and Munger all HATE Diversification : World’s Greatest Investors” shows interview clips in which Warren Buffett, Mark Cuban, and Charlie Munger comment on diversification.
There are several layers in Warren Buffett’s argument. The first one is that if you know the business you invest in and you know security analysis, then you don’t need to diversify. This is based on the presumption that your knowledge about businesses and your security analysis are correct. However, it is a difficult thing to do and a lot people think they are correct but they are not in reality.
The second layer is that Berkshire is willing to hold only one asset if Berkshire really knows about that asset. There are again two problems with this — (1) Berkshire does not hold only one assets. Instead, it revealed holdings include about 44 stocks from 6 sectors. Is that a diversified portfolio? To learn that, we need to look into the correlations among the assets, because the benefit of diversification is primarily from non-perfect correlation.
Nothing fancy. Just an excel sheet can help us see that the majority of his portfolio components do not correlate much with other assets. The resulted portfolio is quite diversified. Additionally, Berkshire also holds gold which negatively correlates with stocks.
Recently, Warren Buffett always recommend investors to hold long position in an ETF. In 2008, Warren Buffett issued a challenge and bet against hedge fund managers about passive investing vs active investing.
Warren won the bet and shows that passive investing, which requires diversification, out performs hedge funds in the long run.
Lastly, a simple buy-and-hold diversification strategy does not necessarily perform worse. Let’s get back to the question at the beginning: if you think Tesla will go up in the long run, why should I diversify? I just want to point out two aspects with respect to this argument:
(1) Everything goes up in the long run, why Tesla? Is it because it has been up so much lately? The argument basically says Tesla is risk free in the long run, but is that the case? Don’t mix up history with future. Even though the small stocks outperforms a lot in 100 years, but no one has 100 years to invest.
(2) The importance of reducing risk comes from the down side. Just imagine if you started with investing $1,000 and lost 50% of it. How many years do you need to recover if your annual return is 10%? The answer is roughly 7 years and that is assuming no big draw downs in the next 7 years. Just imagine that you were retiring next year and this happened. Then you cannot retire for the next 7 years. During Trump’s administration, there has been two major drawdowns. Even though the market seems doing well, these two drawdowns cause a very so so performance in the past 4 years when comparing with the stock market performance under other administrations.
The success of Warren Buffett is largely due to his performance before 2010. [It is incredible. Don’t get me wrong.] In the most recent 10 years, Berkshire has not been doing so well. It has been very similar to S&P 500.
A comparison between Carl Icahn, an activist, and Warren Buffett, a passivist:
Given all these crazy numbers, the Nasdaq index out performs them all. If one just holds the Nasdaq index, which is a diversified portfolio, he will outperform all the professional investors.
I hope this article helps you get a better idea about diversification and what diversification means to investors. Holding a diversified portfolio is not necessarily a bad choice for a lot of people who are looking to achieve good risk-return trade-off without spending too much effort in it.