Reducing risk while enhancing returns sounds like a perfect dream. But what if diversification, our supposed safety net, is holding us back? Let’s rethink investing: it’s not about owning more but owning better.
Reducing risks and increasing returns at the same time: A thought on a beautiful winter’s night that sounds too good to be true, doesn’t it?
This idea sounds appealing yet implausible – especially if you have learned that less risk equals more diversification. The concept of diversification has been a cornerstone of modern portfolio theory since the work of Harry Markowitz in 1952. It teaches us that spreading investments across a wide range of assets reduces overall risk by minimizing the impact of the failure of a single investment – the stock-specific risk.
While the premise is sound, I argue that its over-application can lead to what Peter Lynch coined as «diworsification» – an overly diversified portfolio where the quality of investments is compromised, and returns are diluted. The result is the illusion of safety in diversification.
The key, therefore, is not to spread investments across hundreds of companies. That is not what Markowitz meant by diversification either.
It is to focus on a small number of exceptional companies.
Chart 1: The dangers of over-diversifying your portfolio: the effect is minimal after 20-30 stocks
Share with your friends. Your support means the world to us.
