Is it dumb to diversify shares or property?
Diversification is not all it’s cracked up to be, according to a man who read my last column, which praised the spreading-your-risk idea.
“Bill Gates didn’t diverse much, and it didn’t do him much harm,” he writes. “The fact remains that the richest people on the planet have become that way because they haven’t diversified.
“Diversification may help you avoid significant losses. However, it also ensures that you will never make significant profits because it dumbs down the returns you make.”
His views are echoed by Robert Kiyosaki in “Rich Dad, Poor Dad”.
“If you have any desire of being rich, you must focus,” he writes. “Put a lot of your eggs in a few baskets. Do not do what poor and middle-class people do: put their few eggs in many baskets.”
Are they right?
Certainly, many of the richest people got that way by taking big risks of one kind or another. But risk-taking can also the road to financial ruin.
And there’s more to it than that.
As I pointed out in my last column, the risk of not diversifying is an unrewarded risk.
Market prices are set by the actions of the big financial institutions, and they all diversify. So there’s no premium built into prices to reward non-diversification.
While some lucky non-diversifiers get very rich, on average non-diversifiers are not rewarded for the risk they take.
If you’re willing to take big risks to get the chance of huge rewards, you might as well take risks for which the market will reward you.
You could, for example, invest in a wide variety of shares that are particularly volatile, such as global shares in mining, high-tech companies and new ventures.
Such shares sometimes become worthless, but they sometimes soar. And their average return is higher than the market average.
Or you could borrow money to invest in a range of shares and/or properties. Gearing boosts both risk and rewards.
Our reader also objects to diversification because “it becomes very difficult to remain close to your investments and make good strategic decisions about them.”
He has found it better to “focus on just a handful of companies which I could spend sufficient time and effort understanding.”
But is that work necessary?
Lots of research shows that an individual investor who researches companies doesn’t tend to do any better than someone who chooses shares at random.
This is because of “market efficiency”. Whenever a company issues new positive information, big institutions buy its shares in seconds. That demand pushes up prices, so by the time individuals buy, the good news is already incorporated in the price.
The same with bad news. Institutions sell fast, lowering the price that individuals can get when they decide to sell.
Individuals can still, of course, do really well with shares. But generally those who do better than the market average are lucky, rather than clever.
You might as well choose shares randomly — in which case it’s just as easy to have fifty as five.
What about property? With every building different, the market is not efficient. If you are the only one who researches a particular property, you could well get it at a bargain price.
But there’s still the eggs-in-baskets problem — which is why I would rather invest in a fund that holds many different types of properties in different locations.
While the reader raises some interesting points, he hasn’t convinced me to drop diversification.
As economist Peter Bernstein says, some investors “look on investing as a game and … fail to diversify; diversification is boring. Well-informed investors diversify because they do not believe that investing is a form of entertainment.”
Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.