Investment: The Myth of Diversification

“Diversification is only required when investors do not understand what they are doing”
– Warren Buffet

Diversification is a defensive strategy to minimize your losses in investing by spreading your risk across different sectors. If you lose here, you make up by winning over there, thus minimizing your losses. Experts and brokers advise their clients to diversify their investments, especially in the context of investing in the stock market. This means investing in stocks across different sectors e.g. banking and finance, manufacturing, real estate, commodities, etc. The mutual fund is built around this concept. The core of the issue is that you are playing a game of chance since you are not in control and cannot determine outcomes. Not being in control is the hallmark of the amateur investor. You are taking a chance. Since you are not sure, you spread your risks.

Putting it very bluntly, you don’t know what you are doing. If you are sure of yourself, you will focus on a winner and maximize your returns on investment. I find the perspective of Rich Dad quite hilarious and straight to the point. Diversification is like betting on all the horses in a horse race since you are not sure of the winner. You can never miss the winner if you bet on all the horses since one horse must win. However, your win is minimal, as you have spread your money equally among losers. It is an expensive way of picking the winner.

There is nothing wrong with diversification if you know what you are doing. There are five major markets namely stocks, real estate, commodities, bonds, and currency markets. In the context of diversification, you are not really diversified if all your investments are in the stock market. Even if you spread across all the sectors in the market, you are still in one market. When that market crashes, it takes everything down with it. Every sector may not take a hit in the same magnitude, but when the bears are on the rampage, everyone ducks for cover no matter the sector.

Folks that diversify in one market always get slaughtered when that market crashes. Diversification does not save you when that market crashes. The wise thing to do is to get out of the line of fire. Exit before the crash. Don’t wait to see which sector is left standing after the crash, if any. If you are investing for cash flow only, then it is a whole new ball game entirely. As long as the cash flow (income from the investment) is not affected, you can ride out the crash knowing that your investment objective is still being met whether the market crashes or booms.

If you want to truly diversify, you have to invest in many markets, and not just one. The problem with diversification is that you can easily fall into the trap of becoming a jack of all trades and master of none. In the world of investing, you need to become a master of whatever you are committing your money. You have to take the markets one at a time. It can take years, sometimes more than 5 years to master one market. The key is FOCUS.

F – follow

O – one

C – course

U – until

S – successful

Follow one course until successful. You can diversify into all five markets, but take it ONE at a time. Master one market before you move into another market. Don’t just listen to brokers and dive in head first. Know what you are doing. When you master a skill, that skill will never leave you. It may become rusty after a long while, but all it needs to come back to life is a little warming up. It is like driving a car or bicycle. The moment you master the skill, it is yours for life.

I rode a bicycle recently. The last time I rode one was in the early eighties in the days of Ronald Reagan as President of the USA. I was afraid I might not be able to ride after more than 20 years. I gathered up the courage to mount the bike, pushed forward, and began to pedal. I regained balance in seconds and it was the eighties all over again. I was back in business.

Focus and win convincingly before you move on. Do not fight too many battles. Few nations can afford to do that. Fight one battle and win before you take on the next. Diversification comes with time after you have paid your dues. When it comes to investing, focus and win before you move on to the next market. If you have not mastered the different markets, diversification is a strategy you adopt when you do not understand what you are doing. You win some, lose some. If the roof comes tumbling down, you are on your own.