The Pain of Diversification
November 8th 2006 10:03
As an investor the idea that causes me the most pain is diversification.
What diversification means, according to conventional wisdom is that, after you buy the investment that matters to you, you should also buy a bunch of other unrelated investments whose performance will hopefully cushion you first move if it goes bad.
I even remember one lecture at University in which a graphic showing an upwards moving investment and a downwards moving one was displayed. The meaning was that, if you buy the upward going company you should also buy the downwards one so that you, in the end, obtain an average gain. I find this amazing.
Diversification was also a corporate fad in the 1970s and 1980s in the area of company mergers. These days companies were more like conglomerates mixing incredible areas of business. The idea was that if, say paper pulp went down, chocolates or something else would go up and so saved the financial performance for the year.
Once it became fashionable all companies felt obligated to go this way.
But this kind of diversification proved to be a great failure and has now been abandoned by nearly all companies. The trend now is that mergers make sense only if there are to be some sort of synergies that will get reflected in the bottom line and the investments must sort of be in the same area of business which, all this, is certainly a lot more sensible.
With regards to the diversifying investor, the question I ask is this: if you're not sure your investment will increase in the future, why then do you invest in it?
I understand the answer: there's a risk element in every investment, but my question then becomes: can you find a company that will not represent a risk for you?
I think this would make much more sense since reducing risks is what diversification purports to be doing. On the other hand, if you really want to run risks, why then diversifying, why not sticking up to your guns?
Because, if you invest 100 and 50 of it go toward diversifying companies, you are only going to get your desired return from 50. The other 50 are probably going to be a waste of capital.
The question, though, that makes more sense to me, and it’s attributed to Warren Buffet, is this: if you know everything about one company, why would you then invest in companies you know nothing about?
Moreover, and also from Buffett, each investor should have a punch card with a limited number of decisions to make to the end of his life, like ten decisions. Once one decision is taken, one hole is punched on the card.
Wouldn't you then make sure that your investment decision was right?
What diversification means, according to conventional wisdom is that, after you buy the investment that matters to you, you should also buy a bunch of other unrelated investments whose performance will hopefully cushion you first move if it goes bad.
I even remember one lecture at University in which a graphic showing an upwards moving investment and a downwards moving one was displayed. The meaning was that, if you buy the upward going company you should also buy the downwards one so that you, in the end, obtain an average gain. I find this amazing.
Diversification was also a corporate fad in the 1970s and 1980s in the area of company mergers. These days companies were more like conglomerates mixing incredible areas of business. The idea was that if, say paper pulp went down, chocolates or something else would go up and so saved the financial performance for the year.
Once it became fashionable all companies felt obligated to go this way.
But this kind of diversification proved to be a great failure and has now been abandoned by nearly all companies. The trend now is that mergers make sense only if there are to be some sort of synergies that will get reflected in the bottom line and the investments must sort of be in the same area of business which, all this, is certainly a lot more sensible.
With regards to the diversifying investor, the question I ask is this: if you're not sure your investment will increase in the future, why then do you invest in it?
I understand the answer: there's a risk element in every investment, but my question then becomes: can you find a company that will not represent a risk for you?
I think this would make much more sense since reducing risks is what diversification purports to be doing. On the other hand, if you really want to run risks, why then diversifying, why not sticking up to your guns?
Because, if you invest 100 and 50 of it go toward diversifying companies, you are only going to get your desired return from 50. The other 50 are probably going to be a waste of capital.
The question, though, that makes more sense to me, and it’s attributed to Warren Buffet, is this: if you know everything about one company, why would you then invest in companies you know nothing about?
Moreover, and also from Buffett, each investor should have a punch card with a limited number of decisions to make to the end of his life, like ten decisions. Once one decision is taken, one hole is punched on the card.
Wouldn't you then make sure that your investment decision was right?
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