15 Apr Diversification Is Misguided Concept?

I believe in the benefits of diversification. Diversification removes security specific risks when we accept that we are not that good at security selection. Diversification across asset classes allows the portfolio to be more resilient in different market cycles. Diversification across strategies reduces the portfolio risk as different strategies perform in different market regimes.

Yesterday I read Stanley Druckermiller’s transcript and among many useful pointers, he said this:

“I think diversification and all the stuff they are teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffet, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s the kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you. And if you look at what excites you and then you look down the road, your record on those particular transactions is far superior to everything else, but the mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.”

Today I’m halfway through Peter Thiel’s amazing book: Zero to One.

This is an excerpt on his thoughts on diversification in the context of startups and venture capital:

“The error lies in expecting that venture returns will be normally distributed: that is, bad companies will fail, mediocre ones will stay flat, and good ones will return 2X or even 4X. Assuming this bland pattern, investors assemble a diversified portfolio and hope that winners counterbalance losers. But this “spray and pray” approach usually produces an entire portfolio of flops, with no hits at all. This is because venture returns don’t follow a normal distribution overall. Rather they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of single-minded pursuit of the very few companies that can become overwhelmingly valuable, you’ll miss those rare companies in the first place. … VCs must find the handful of companies that will successfully go from 0 to 1 and then back them with every resource”.

Diversification has its importance. It depends on a range of factors including ability to find conviction, nature of investments and industry, nature of the winning edge, the probability of having a winner etc.

Perhaps diversification serves the majority of us well while top guys (such as Stanley Druckermiller and Peter Thiel) swing for the fence with their high conviction (and successful) bets.