In February 2000, a financial advisor named Bob Markman wrote an article that got a huge amount of attention online. Called “A Whole Lot of Bull*#%!” (that’s how the original was spelt) and published by Worth magazine, the article attacked the idea of diversification, arguing that any money put into currently underperforming investments was money wasted. Internet and other technology stocks had been so hot for so long that nothing else was worth owning, Markman argued. He was far from alone in saying that.
Markman and I exchanged long emails and even longer letters (that’s how people communicated in those Neolithic days), but the “debate” boiled down to one point: Can the typical investor predict the future with precision, or not? Markman insisted the answer was yes. I felt then, as I still do, that the answer was no.
In Markman’s defence, there is a case to be made that if you have inside knowledge or superior analytical ability, then you should bet most or all of your money to capitalize on it. Warren Buffett and Charlie Munger have long argued exactly that. If you are as analytically brilliant as Buffett or Munger, diversification will lower your returns. The rest of us, however, should have much less courage about our convictions. And inside knowledge or superior analytical ability are best applied to individual securities, not to broad market views.
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We’re all susceptible to confirmation bias – paying more attention to our own preferred data and largely ignoring contradictory evidence. For investors, this psychological blind-spot can be very costly.
In every-day life, we like to think that our decisions are logical, rational and objective but often they are anything but.
Balanced analysis frequently goes AWOL as our pre-conceived beliefs take over. Let’s take a General Election as an illustration of this point.
Voters often seek positive news that shows their favoured candidates in a glowing light while paying scant attention to information that casts the opposing candidate in a good light.
If their existing belief is that their party is always strongest on say, maintaining law and order, they may place greater emphasis on campaign speeches reinforcing this claim than independent figures showing cuts in police or army numbers.
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“There is one other rule you ought to keep in mind and that is to concentrate, and not only in the Zen sense. Sweet are the uses of diversity, but only if you want to end up in the middle of an average” Adam Smith, the Money Game 1968
“Statistical analysis shows that security-specific risk is adequately diversified after 14 names in different industries, and the incremental benefit of each additional holding is negligible. We own 18-22 companies to allow us to be amply diversified but have the flexibility to overweight a name or own more than one business within an industry.” Mason Hawkins
“Empirical testing has proved beyond a reasonable doubt that the “riskiness” of a portfolio of 12-15 diverse companies is little greater than one loaded with a hundred or more” Frank Martin
“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally. ” Warren Buffett
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