The mantra of almost all investors and personal financial planners is to diversify your stock portfolio. It certainly does protect you from losses as you don’t have to worry about company specific risk. If you diversify your assets too much there will be a point where you just end up mimicking the markets. These aren’t bad things. You lower your risk and the worst thing that can happen is that you will have average returns. If this is the case, then why is this the title of the article? Why am I saying that diversification is for suckers?
The answer comes from the sage of investing, Warren Buffet. It’s amazing that Warren Buffet is actually ignored in the investment community. He’s the best investor of all time and professionals do the exact opposite of what he does. Maybe that’s why he’s rich and they are just making money on fees instead of actually having profits that beat the market.
Diversifying among your stock investments for a lot of retail investors is simply buying many companies that they don’t know a lot about instead of buying one company they don’t know anything about. That’s probably a good strategy if you assume that you know nothing. A better way to lower your risk, in my opinion, is to research the companies that you own and bet the farm on your best picks. Knowledge is the key to lowering your risk because if you know a great deal about the company you will be able to spot a problem that may be arriving in the future.
Warren Buffet invests in what he knows and never shies away from investing a large percentage of his wealth in a high quality company selling at a cheap price. The fact of the matter is the only way to lower your risk in a stock is to read the annual report and study the financials. If everything checks out well and the stock is trading at a cheap price then why not invest a large part of your portfolio in one company? If you know a stock is undervalued and have a long term time horizon then you should not diversify; you should put your capital in that one stock. This is the way that you will get amazing returns.
My friend was huge believer in Tesla Motors and knew everything about the company in 2013. He owned only that one stock and made a huge profit in it after it boomed earlier this year. He would have made a lot less money, if he only had 20% of his money in the stock. The point is that the market is inefficient. Stocks are always undervalued and overvalued. If you can spot a very cheap stock that has a great business model then why would you only invest a small amount of your money in the stock? Obviously there is risk in this behavior, but in my opinion you wipe away that risk by your immense level of research in the company. Eventually the time will come when the market realizes that it is undervaluing a company and you will have huge gains.
If you don’t know a great deal about the stock market it’s better that you just buy an index fund, but if you do then I would argue against diversification. Warren Buffet doesn’t look at the price a stock is trading at before he reads through the financials. He comes up with a price and then checks whether it is above or below what it is currently selling at. Maybe you should listen to Warren Buffet instead of the talking heads on CNBC!
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