Martynas Stankevicius. Managing Investment Risks: Many Baskets or Proper Care for One?
Diversification is an investment strategy that financial experts almost unanimously recommend to reduce the risk of losses. But Warren Buffett has said that diversification only protects against indifference and is worthless for those who have deep knowledge in one sector. Although for less experienced investors, diversification is generally a healthy practice.
Investment diversification or the distribution of capital across multiple directions is inherently a commendable strategy, illustrated by the proverb about not putting all your eggs in one basket. In certain situations, diversification immediately creates tangible value.
A prime example of this value is the deposit insurance operating in Lithuania: the state-owned company “Ind?li? ir investicij? draudimas” guarantees protection for a depositor up to EUR 100,000 in one credit institution. Any amount exceeding this in the same bank would not be insured, but by depositing it in another bank, the state's guarantee would apply again. Moreover, the likelihood of both credit institutions going bankrupt at the same time is lower. This is a win-win diversification strategy, doubling the maximum amount protected by deposit insurance and increasing theoretical liquidity.
Diversification in more complex investment decisions—such as in stocks, bonds, funds, currencies, platforms, real estate, etc.—is also inherently harmless. The logic here is simple: spreading money across different directions reduces the impact of individual unsuccessful choices on the entire portfolio. It’s hard to imagine a scenario where, for example, Microsoft shares plummet, the dollar’s value drops, the German government fails to meet its obligations, an investment fund collapses, a business loan is defaulted on, and a rental property burns down all at once, although such scenarios are not impossible individually. The same principle applies to diversifying within the same asset class—five different company stocks are theoretically less risky than just one.
However, this is where the drawbacks and risks of diversification begin. Are those five stocks purchased just to be different, or because the investor thoroughly understands each one? Without even delving into the typically reduced potential profits and increased administrative costs due to diversification, a common consequence of spreading investments is the deterioration of investment decision quality. It’s great if the investor can thoroughly examine each choice and “get it right” every time, but diversifying for the sake of diversification, especially in less familiar areas, can distract and create risks no less significant than those of a single, well-understood and stable “basket.”
When diversifying, investors typically try to escape known risks. The problem is that few people can understand most of the known risks across different sectors, and there are also unknown risks. For example, buying an apartment in Tenerife a year and a half ago seemed like a great investment simply because “war is less likely to happen” on this island. However, Lithuania has been systematically insuring itself against such a risk for nearly four decades, and not everyone knows that there’s an active volcano in Tenerife. Even if they do know, it’s almost impossible to predict the timing of its next major eruption. Finally, markets always face “unknown unknowns” like Covid.
Therefore, I understand W. Buffett's point about ignorance. If you don’t want or are unable to delve deeply, but strive to maintain time-tested investment positions, diversification won’t be a bad strategy. It will reduce the risk of losses, but it will also limit potential profits. In W. Buffett's own portfolio (i.e., his company's), there are shares of about 50 different companies, but just five of them – Apple, Bank of America, American Express, Coca-Cola, and Chevron – make up nearly 80% of the entire portfolio’s weight. In fact, Apple alone accounts for 49% of W. Buffett’s portfolio. In other words, this living investment legend diversifies in a limited way, placing the biggest “eggs” in well-understood and thoroughly analyzed “baskets”.
So, to paraphrase W. Buffett, diversification is generally worth it, but it would be even more valuable to constantly deepen your knowledge in at least one area. By better understanding at least one sector, we can not only make better investment decisions but also diversify more effectively.
Martynas Stankevicius. Managing Investment Risks: Many Baskets or Proper Care for One?
Diversification is an investment strategy that financial experts almost unanimously recommend to reduce the risk of losses. But Warren Buffett has said that diversification only protects against indifference and is worthless for those who have deep knowledge in one sector. Although for less experienced investors, diversification is generally a healthy practice.
Investment diversification or the distribution of capital across multiple directions is inherently a commendable strategy, illustrated by the proverb about not putting all your eggs in one basket. In certain situations, diversification immediately creates tangible value.
A prime example of this value is the deposit insurance operating in Lithuania: the state-owned company “Ind?li? ir investicij? draudimas” guarantees protection for a depositor up to EUR 100,000 in one credit institution. Any amount exceeding this in the same bank would not be insured, but by depositing it in another bank, the state's guarantee would apply again. Moreover, the likelihood of both credit institutions going bankrupt at the same time is lower. This is a win-win diversification strategy, doubling the maximum amount protected by deposit insurance and increasing theoretical liquidity.
Diversification in more complex investment decisions—such as in stocks, bonds, funds, currencies, platforms, real estate, etc.—is also inherently harmless. The logic here is simple: spreading money across different directions reduces the impact of individual unsuccessful choices on the entire portfolio. It’s hard to imagine a scenario where, for example, Microsoft shares plummet, the dollar’s value drops, the German government fails to meet its obligations, an investment fund collapses, a business loan is defaulted on, and a rental property burns down all at once, although such scenarios are not impossible individually. The same principle applies to diversifying within the same asset class—five different company stocks are theoretically less risky than just one.
However, this is where the drawbacks and risks of diversification begin. Are those five stocks purchased just to be different, or because the investor thoroughly understands each one? Without even delving into the typically reduced potential profits and increased administrative costs due to diversification, a common consequence of spreading investments is the deterioration of investment decision quality. It’s great if the investor can thoroughly examine each choice and “get it right” every time, but diversifying for the sake of diversification, especially in less familiar areas, can distract and create risks no less significant than those of a single, well-understood and stable “basket.”
When diversifying, investors typically try to escape known risks. The problem is that few people can understand most of the known risks across different sectors, and there are also unknown risks. For example, buying an apartment in Tenerife a year and a half ago seemed like a great investment simply because “war is less likely to happen” on this island. However, Lithuania has been systematically insuring itself against such a risk for nearly four decades, and not everyone knows that there’s an active volcano in Tenerife. Even if they do know, it’s almost impossible to predict the timing of its next major eruption. Finally, markets always face “unknown unknowns” like Covid.
Therefore, I understand W. Buffett's point about ignorance. If you don’t want or are unable to delve deeply, but strive to maintain time-tested investment positions, diversification won’t be a bad strategy. It will reduce the risk of losses, but it will also limit potential profits. In W. Buffett's own portfolio (i.e., his company's), there are shares of about 50 different companies, but just five of them – Apple, Bank of America, American Express, Coca-Cola, and Chevron – make up nearly 80% of the entire portfolio’s weight. In fact, Apple alone accounts for 49% of W. Buffett’s portfolio. In other words, this living investment legend diversifies in a limited way, placing the biggest “eggs” in well-understood and thoroughly analyzed “baskets”.
So, to paraphrase W. Buffett, diversification is generally worth it, but it would be even more valuable to constantly deepen your knowledge in at least one area. By better understanding at least one sector, we can not only make better investment decisions but also diversify more effectively.
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