Diversification is a key tenet of investing. It ensures that no investor is reliant on a small number of assets for their returns. Perhaps more importantly, though, it reduces the impact of poor returns among a small number of holdings in a wider portfolio. As such, mistakes made when allocating capital can prove to be less impactful on a diversified portfolio than on a concentrated portfolio over the long run.
However, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) has previously suggested that diversification may not be necessary for all investors. He said, “Wide diversification is only required when investors do not understand what they are doing.”
In my view, Buffett’s advice is pertinent. Too much diversification – or "wide diversification" as he describes it – can be detrimental to portfolio returns. After all, an investor’s best idea is likely to be superior from a risk-reward perspective than their second-best idea, and so on. As such, ensuring a portfolio is well-diversified can, in some cases, lead to investors purchasing stocks that do not necessarily offer favorable long-term return outlooks.
Risk-reward considerations
Of course, the stock market’s track record shows that unforeseen risks and events frequently occur. Even the most experienced investors can make mistakes when apportioning capital. Moreover, even the most financially sound businesses with the widest economic moats can experience challenging trading conditions due to macroeconomic or political events that cause their market valuations to materially decline. In some cases, they never recover.
Clearly, Buffett is not suggesting that all diversification is bad. Indeed, his track record of investing shows that he has always held multiple stocks within Berkshire’s portfolio. He does not invest all capital in only his best idea. However, Berkshire Hathaway is a relatively concentrated portfolio that may be less diversified than the portfolios of other prominent value investors.
As such, it could be argued that personal choice is key to obtaining the appropriate level of diversification within a portfolio. Some investors may be comfortable owning a limited number of stocks and could feel that wide diversification is unnecessary given their relatively high level of risk tolerance. Other investors, meanwhile, may decide they cannot take the risk that a small number of holdings will have a significant effect on their portfolio and long-term wealth.
A useful approach?
In my view, there is no one-size-fits-all answer to the question of how diversified a portfolio should be. Clearly, some diversification is a prerequisite of investing due to the unforeseen circumstances that can affect stock prices. Equally, though, investing in companies just for the sake of reducing risk, rather than because they offer exceptional return opportunities, may represent an inefficient allocation of capital.
Therefore, Buffett’s views should be considered useful in prompting value investors to assess their own needs when it comes to diversification. However, as is often the case, taking them literally could lead to unacceptable levels of risk for many value investors.
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