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How to Avoid Over Diversification of an Investment Portfolio

Alexander is an entrepreneur, businessman and investor, based in the UK!

Learn more about over diversification and how it can harm your portfolio.

Learn more about over diversification and how it can harm your portfolio.

We've all been there—fighting the urge to go into the stock market and purchase a small amount of shares in maybe 20 companies. But trust me, you do not want to do that!

I too have had this urge, indeed many moons ago. Thankfully, I did not do this, but if I had, I would've kicked myself for it and never forgiven myself.

When you look at the most successful investors—Warren Buffett, Charlie Munger and George Soros (to name but a few)—they've all invested in a mere handful of companies. Charlie Munger is a prime example: He only has holdings in three companies!

Why Do Top Investors Only Invest in a Few Companies?

You are probably sat there thinking, "What do some of the world's greatest investors know that I don't?"

And you are right. They do know something that you don't. They follow a simple principle of investing, often referred to as "Rule One Investing". This is a theorem set out by legendary investor Benjamin Graham (who also happened to teach Warren Buffett about investing!).

In part, the theory states that you should know every detail about that business (or almost everything about that business). This means that if I (for some unknown reason) walked up to you in the street and said, "Tell me about [insert name of the company you have invested in]," you should be able to tell me the following:

  1. Where the business is located
  2. The main C-Suite executives (CEO, COO, CIO etc.)
  3. The stock holdings of those C-Suite executives (ie. Do they own stock in their own company?)
  4. Main source(s) of revenue
  5. Competitors
  6. That company's competitive advantage (something of your own opinion, not what you read on a random blog post from three years ago)
  7. Are the company's founders part of the management (or their children if they are too old)?

Obviously, with twenty companies, there is literally no way that you can do this. Even with ten companies, I think it might be a stretch.

An Old Adage About Investing

In the investing world, there is an old adage that goes along the lines of:

Risk comes from not understanding what you're investing in.

And this adage has proven true, time and time again.

By investing in 15, 20 or even more companies, you make it incredibly difficult for you to know and understand (in depth) a business you are trying to invest in.

How Can I Do This?

Doing this is quite simple. There is very little that can go wrong—providing you follow Rule One Investing philosophy.

I would always recommend that you go and invest in one company at a time. Don't rush in and use $25,000 to invest in 5 companies that you've been researching for six months. Invest $5,000 at a time, in one of the 5 companies.

The only time you should ever deviate from this is when there is a market crash. Take the Great Recession (2007–2009(ish)): It was one of the worst crashes we've seen since the Great Depression of the 1930s.

To quote Warren Buffett:

When it's raining gold, go outside with a bucket, not a thimble

When stock prices are falling through the floor like there's no tomorrow, that's when you disregard that rule and invest the whole way!

But, now I'm getting ahead of myself.

What Is Over Diversification?

Whilst we have touched on it, I haven't told you what over diversification really is. Over diversification is defined as:

An excessive or more than necessary number of stocks that you hold

Essentially what this means is, when you own more companies than you can reasonably know about.

Whilst I'm not going to sit here and tell you that you should keep all of your money in one company (which is generally considered to be a stupid idea), I will say that some diversification is necessary, and even beneficial to your portfolio.

By investing in multiple companies, you allow yourself to have a certain amount of freedom. It allows you to profit not only from the ups and downs of each company, but also something no ETF, Mutual Fund or financial adviser can offer. Security.

Reliability Breeds Responsibility

Because, whilst buying too many companies will leave your portfolio too weak to stand on its own during a recession (as you don't have high enough equity in one company as you would if you diversified well), buying a reasonable amount of companies will set you up in good stead for many years.

"Reliability breeds responsibility" as a friend of mine used to say.

If you have reliable stocks that you don't have to worry about collapsing every thirty seconds, that breeds a sense of responsibility. Not only for you as a part-owner of the company, but also the corporation itself. If it knows that you (and the other investors) seriously believe in them, they will do better. Not just on the stock market, but in general.

How Can I Avoid Over Diversification?

You can avoid over diversification by a few simple steps:

  1. Refrain from letting your emotions get the better of you
  2. Do your research, but stick to a few stocks
  3. Only buy one stock at a time
  4. Meditate

Yes, meditate! Meditation will allow you to focus yourself. You will be able to focus your mind on the investment: "Is it the best investment? Is this company the best it can be?"

And once you can answer those, you can be sure that you will avoid over diversifying your portfolio!

© 2020 Alexander Pask

Comments

Anya Ali from Rabwah, Pakistan on January 31, 2020:

Informative and well-written article. Thank you for posting it here.

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