Peter Lynch used to say, if you are not thoughtful, diversification will soon become “diworsefication”. Indeed, the term diversification is frequently mentioned in various finance articles, books and speeches, however, the concept is often misunderstood. A lot of people think diversification as buying a lot of different things at once. Nothing can be further from the truth.
Normally good ideas are rare and sometimes if you can have 10 or 20 good ideas, consider yourself lucky. To create a strong portfolio, you would like to concentrate your money to these best ideas, and never spend a dime on some other overpriced securities just under the name of “diversification”. Because a dollar deployed on an expensive asset is a dollar going to generate subpar return for you, there is nothing great can come from this dollar. Say, if you have a group of stocks that you conservatively to return 50% to 100% over holding period, what will be the reason ever to allocate another 25% to 50% to long dated treasury bonds that come with fixed income, ceiling on the principal and most importantly, priced at an extremely expensive level? The traditional wisdom of stock and bonds both in a portfolio is not going to help you when bonds are traded at 50 times of their fixed earnings (for example, a 2% yield bond at par).
The key spirit of diversification, is that you should not stop at your first idea and concentrate your wealth 100% on it. Because business risks are real, and sometimes you may suffer a bit of lack of luck, even you have high conviction on some stock ideas, you should be prepared that it may not realize at the timing that you expected, or the business condition may well change after you bought the stock. Therefore, the right way to diversify your holdings, should be methodically evaluating opportunities all the time, one-by-one, to add opportunities that are expected to deliver satisfactory returns into your portfolio. And never stop there. You should always keep learning and looking for the next best one.
- You diversify into buying the next value opportunity, not because you have to buy it for the name of diversification.
- Don’t diversify into a class of assets. Only pick the best one!
- Take your time to diversify into various fields, sometimes it may take years.
- If nothing is available, keep cash.
This is also part of the fun in this business: never settle and always learning and looking for the next great value opportunity.