Why diversification beats concentration for most investors?

It’s time to revisit my favorite Howard Marks anecdote:

“I tell my father’s story of the gambler who lost regularly. One day he hears about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away.” — Howard Marks, The Most Important Thing: Uncommon Sense for the Thoughtful Investor

There are two strategies investors can deploy to manage the risks posed by an uncertain world. One approach would be to acquire superior skills and knowledge and deploy them to pick the winners every time. This can also be understood as your pursuit of immaculately perfect decision-making, leading to the maximisation of wealth. The second approach is diversification, which emphasises the management of volatility and your ability to sleep well at night. This strategy is about managing the risks involved in reaching your financial destination. It does not emphasise the fastest route to your destination.

At this point, many may point to the Oracle of Omaha, Warren Buffet, who said: “Diversification is protection against ignorance… It makes little sense if you know what you are doing". This statement leads to the belief among some investors that concentrated portfolios will make them rich. They feel diversification is for the ignorant and they are far from ignorant. And that none other than the Oracle of Omaha is backing their approach!

However, I could also make a case for the opposite by pointing to the record Peter Lynch – manager of the Fidelity Magellan Fund from 1977-1990¹. He typically ran the fund with over 1,000 companies and racked up stellar return of 29.2% annualized return over the period, handsomely beating the benchmark². Peter Lynch is also the author of the best-selling investment book “One up on Wall Street”.

The purpose of this note is to make the case that for most investors—whose purpose of investing is to achieve their financial goals—diversification is the approach best suited to their needs and requirements. Volatility is inherent in the investment journey that involves equity, and you can manage that risk via diversification. Diversification also helps you sleep better at night.

Diversification can be practiced at the level of asset classes. In the Table below, we chart the return of different asset classes over time. The maximalist strategy would be to move between asset classes to maximise the best possible return every year. In the real world, this is infinitely more difficult due to the impact of taxes. The best asset class in terms of real returns over long periods is equity. It protects you from inflation and creates wealth. However, it is also notoriously volatile as you can see in the Table below. That is why it makes sense for investors to diversify asset classes. This provides stability to the portfolio and enables you to remain invested through turbulence in the markets. 

Asset Class Performance – 1 Year Returns

Source: MFI Explorer, RBI; Equity – Nifty 50 TRI, Bond – ICRA Composite Bond Fund Index, Liquid – ICRA Liquid Index, Gold – Prices of Gold, Property – RBI: House Price Index

Another leg of diversification is across sectors. Sectors can go through periods of outperformance and underperformance. This is visible in the Heat Map below that highlights the best and worst performers of every year. Choosing only the best performers and avoiding the worst performers is a maximisation strategy, which is very hard to do. A diversified portfolio of companies is the best way to participate in equities.

Sectoral Performance – 1 Year Returns

Source: MFI Explorer; Auto – Nifty Auto TRI, Fin. Services – Nifty Financial Services TRI, FMCG – Nifty FMCG TRI, Infrastructure – Nifty Infrastructure TRI, Healthcare – Nifty Healthcare TRI, IT – Nifty IT TRI, Media – Nifty Media TRI, Pharma – Nifty Pharma TRI, Realty – Nifty Realty TRI

Concentration can be the route to an unwanted destination: financial ruin. Being concentrated in the wrong company or stock has the opposite consequence of making a fortune. Think of the companies that don’t exist anymore such as Jet Airways, Videocon Industries and Bhushan Steel, where equity holders were wiped out. Concentration in a single company can be ruinous. Concentration in a single asset class, geography, sector or market cap can all prove prejudicial to your ability to navigate the volatility of markets.

In the words of the investment thinker and author Peter L. Bernstein (Capital Ideas, Against the Gods, The Power of Gold and Capital Ideas Evolving):

‘Understanding that we do not know the future is such a simple statement, but it’s so important. Investors do better where risk management is a conscious part of the process. Maximizing return is a strategy that makes sense only in very specific circumstances. In general, survival is the only road to riches. Let me say that again: Survival is the only road to riches. You should try to maximize return only if losses would not threaten your survival and if you have a compelling future need for the extra gains you might earn.’

This has been a week of heightened volatility driven by the General Elections. Much blame has been laid on the exit polls leading up to the actual outcome. In this context, I am reminded of a real-life story narrated by Nobel Laureate and American economist Kenneth J. Arrow.

During the Second World War, Arrow, a young weather forecaster for the U.S. Air Force, was charged with making predictions for the following few months. Arrow quickly realised that these long-range forecasts were effectively useless, no better than random numbers pulled out of a hat. He recommended to his bosses that this forecasting should be discontinued. The reply came back, “the Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes”³.

1. Fidelity Magellan Fund
2. How to Invest Like Peter Lynch
3. About Arrow, Kenneth Joseph