Diversification Reduces Risk, But Too Much Reduces Rewards

Diversification is necessary. In the worst case scenario, it prevents you from losing all your money on a single mistake. But overdiversification is self-defeating. Chances are, your twentieth idea won’t be anywhere near as good as your first five ideas.

Here’s a simple example to illustrate how overdiversification can prevent you from building wealth effectively:

Let’s say you have a million dollars to invest. You put all of it into one stock. This stock doubles. You now have $2,000,000. That’s a 100 percent gain!

Now rewind the tape back to the beginning. You still have a million dollars. But this time you use only 1 percent of your one million dollars to buy the same stock. That’s $10,000. You invest it and the stock doubles. You now have $1,020,000. That’s only a 2% gain.

If you’re an investor who doesn’t really know what they’re doing, diversification can save you from destroying your account.

But if you’re investing to build wealth and you know how to value companies, there is no justification for deploying only 1% of your capital into an idea that probably took you two months to research. If you only invested 1% of your money each time you did two months of research, it would take you over 16 years at best to deploy the other 99% of your capital. While that is an extreme example, the point is you must work towards the conviction that will give you the confidence to bet big. This is the reason why you must work hard in the research phase: to have conviction.

Attaining conviction on a stock is a long process. So when you find a stock that checks out on all your criteria, buy hard and MAKE YOUR INVESTMENT COUNT; plow as much money into the idea as you can psychologically withstand. Warren Buffett notoriously put 65% of his money into GEICO when he was in his 20’s. Today he has all his money in just one stock: Berkshire Hathaway.

While I may not be as bold as Warren Buffett to put nearly 70% of my money into a single stock (or perhaps I just haven’t found my GEICO yet), I am a firm believer in concentrating money into your best ideas.

The point of investing is to build wealth, and you can’t do that if you’re jabbing timidly at your best ideas with overdiversification.

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