Diversification matters?

Hello everyone,

I hope this message finds you in good health and high spirits. Today, I'm excited to share my perspective on portfolio concentration and diversification, concepts that are often seen as two sides of the same investing coin. Financial advisors, almost uniformly, advise diversification as a safeguard against market volatility. But is diversification really the golden ticket? Let's delve deeper and find out.

Firstly, let's revisit some theory. Diversification can take various forms:

1. Currency diversification: This involves having assets in various currencies to hedge against foreign exchange rate risks, which are too significant to ignore. Many investors allocate a substantial part of their wealth to foreign assets to take advantage of diversification benefits and to explore more uncorrelated return opportunities outside their home country. However, it's essential to understand that currency diversification is not a one-size-fits-all strategy. It needs to be customized to individual circumstances, like risk tolerance, investment priorities, plans, and existing currency exposures​1​.

2. Country diversification: The idea here is to invest in different countries to protect against country-specific risks. Despite financial integration due to globalization, the benefits of international diversification have not disappeared. It can be particularly beneficial in the long term, as country correlations do not exhibit an ever-increasing trend, and they tend to drop to lower levels as the effects of crises decay over time. Evidence suggests that broad global diversification remains a prudent strategy​2​.

3. Asset class diversification: This approach involves spreading investments across various asset classes like stocks, bonds, real estate, etc. The underpinning theory here is Markowitz's Modern Portfolio Theory, which posits that an investor can construct an optimal portfolio by considering the relationship between risk and return among various assets. The goal is to maximize return for a given level of risk.

Now, let's address the elephant in the room - does diversification work in value investing? And why do most top investors seem to prefer concentrated portfolios? Unfortunately, I couldn't find sufficient data to address this question. It's a topic that deserves further exploration, and I will endeavor to provide more insight in future newsletters.

For active investors, it's worth noting that diversification is not about having your fingers in many pies, but about risk management. It's a tool that allows you to balance potential losses in one area with potential gains in another.

Passive investors, on the other hand, might find wisdom in Warren Buffett's approach. As he once stated, "Diversification is protection against ignorance. It makes little sense if you know what you are doing." If you've done your homework and are confident in your understanding of a business, concentration might serve you well.

In conclusion, whether to choose diversification or concentration is not a binary decision. It's a strategic one, dependent on numerous factors, including your investment goals, risk tolerance, and investment expertise. Remember, there's no one-size-fits-all approach in investing.

I hope you found this discussion enlightening. As always, I look forward to hearing your thoughts and continuing our exploration of the world of investing together.