The Downside of Diversification
One of the most widely accepted principles of investing is you must diversify to reduce risk.
Unfortunately, there's a problem with diversification. While you may reduce your risk, you also lower your chance to generate market-beating returns. Value investors strive to find quality opportunities at a discount so they can beat the market without depending on diversification.
A diversified portfolio holds enough stocks to reduce the risk of any one stock or sector from decimating the portfolio’s value. The problem is the more stocks you own, the more difficult it is to beat the market.
For example, suppose you have a portfolio of four stocks and you're fortunate enough to own a stock that doubled in price. The remaining three stocks remained even. Your portfolio is up by +25%. Way to go!
Now suppose you own 10 stocks in your portfolio and one doubled in price. You're up only +10%. And if you own 20 stocks, your return drops to +5%. The more stocks you hold, the more they tend to dilute your returns, driving you toward the market average.
Reducing the risk of loss is the purpose of diversification. In A Random Walk Down Wall Street, Burton Malkiel, a professor of economics and finance at Princeton, promotes the theory that because of market efficiency, stock prices move randomly. If you believe this theory, then owning more stocks reduces any chance you have to beat the market. Of course, it also minimizes the chance that your portfolio will perform worse than the market.
Value investors reduce the risk of a loss by finding quality companies and buying them at a discount. They prefer to own a few quality stocks bought at bargain prices rather than owning a diversified portfolio of companies.
When you buy a stock that is well below its intrinsic value, you achieve a margin of safety that minimizes the risk in your portfolio. This focus on quality companies acquired at a bargain allows value investors to lower their risk without experiencing the problems stemming from diversification.
Another way value investors lower their risk is by understanding their companies deeply. This insight gives them an advantage over investors who own many stocks. How can you truly understand more than 10 companies at a time? Owning too many companies increases your risk that something might be happening without your knowledge.
By focusing on ways to minimizing their risk of a loss, value investors are able to achieve better returns that can beat the market consistently. This gives them an advantage over diversification alone.
The success of value investors comes from their focus on actively reducing their risk rather than depending on broad diversification to do it for them. Buying good companies at a discount minimizes your risk of a bad buy. Rather than own a broad number of stocks, value investors find that the insight they gain from focusing their efforts on a few quality companies pays off.
If you're a value investor looking for more wealth-building ideas, check out our tutorial How to Invest Alongside the Great Value Investors for more tips.