Diversification and Risk

By:
Robert Sinclair

Diversification as a sacrosanct rule for investment never made sense to me, especially if you have the inclination, knowledge and time to do otherwise.

To me, uninformed diversification is not investing; it is gambling. On the other hand, value investing – is the strategy of investing in securities trading at an appreciable discount from underlying value. If you do this, what is the need to diversify?

I am writing this on Sunday night, August 14, 2022, at 9:04pm and just clicked on the Bloomberg Billionaires Index.

The table is updated daily, and as I write, the top ten can be shown below.

As the table clearly shows, none of the top 10 billionaires on the list made their fortune by “diversification.” If you browse through the remainder of the list, it will clearly show that the majority of the world’s billionaires did not make their fortune by diversifying. The majority created or joined a business that either sold a product(s) or service(s) in one specific industry.

This clearly goes against most of the investment advisor’s philosophy of the need to diversify to become wealthy.

Forbes Annual Global 2022 Billionaires List counts 2,668 billionaires. Interesting to note that only a handful are investment advisors… Curious to know how many of their clients became billionaires as a result of their diversification efforts? I am sure you can guess the answer.

If you are reading this and you made your hard-earned fortune creating your own business, you did so by understanding your business, product or service, customers, sales, marketing, logistics, your competitors, and your overall industry.

If you did not keep yourself updated and informed by these and did not manage and adapt accordingly, your business would have died.

When innovation or disruption occurred, you had to innovate and adapt; otherwise, your business would have died.

Many times, investment advisors suggest that one needs to put money in a diversified portfolio. Many diversified portfolios or mutual funds have too many companies within them for anyone or any team to really be able to keep fully informed of these businesses with any adequate informed insight. This type of diversification is very risky. The unfortunate fact is that most financial managers do not partake in the risk that they take with your money.

Investment managers make money (fees) regardless if the value of your portfolio goes up or down. To keep the math simple, if your portfolio is worth $10 million and the fee you pay your investment manager is 1% of your holdings, then at the end of the year, you would pay them $100,000. If the next year, your portfolio dropped to $9 Million, your investment manager would still make $90,000 for the pleasure of losing $1 Million of your money.

When you ran your own business, if you lost money one year, you did not pay yourself. If you made money, you paid yourself.

The point I am trying to make is that most investment advisors, money managers, and fund managers that invest in tens if not hundreds of companies do not know as much about the businesses that they are investing in, with your money no less than you did running your own business. Does this seem less risky or riskier to you?

"The whole secret of investment is to find places where it's safe and wise to non-diversify. It's just that simple. Diversification is for the know-nothing investor; it's not for the professional." Charlie Munger

"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is got to be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So, I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don’t diversify personally." Warren Buffett

To understand how portfolio diversification came to be in the investment industry, I suggest you read the following:

  • Where Are the Customers' Yachts? by Fred Schwed
  • Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth A. Klarman
  • The Clash of the Cultures: Investment vs. Speculation by John C. Bogle
Footnotes

Disclaimer
The views and opinions expressed in this article are those of the author and do not necessarily reflect the views or opinions of Olympia Trust Company, Olympia Financial Group Inc., or any of its affiliates. The author’s views and opinions are based upon information they consider reliable, but neither Olympia Trust Company, Olympia Financial Group Inc. nor any of its affiliates, warrant its completeness or accuracy, and it should not be relied upon as such.

Robert Sinclair
Senior Business Advisor, Inno-centre

Robert Sinclair has 20+ years of executive and board-level advisory experience with multinational corporations (private & public), pension funds, private equity, development firms, hedge funds, single family offices, and Military and NGOs. ESG & sustainability advisory, due diligence, asset management, risk reviews, root cause analysis, comparative gap analysis, ROI calculation, business plans, market research, value proposition analysis, development & articulation, compliance auditing, M&A, digital solutions, condition assessments, strategic capital planning, change management and the creation and management of an award-winning internet-based integrated risk management system in the early 2000s.