The Dangerous Illusion of Being Diversified

Are you diversified? The other day a woman mentioned that she had read that diversifying would reduce risk, so she had bought a bunch of different ETFs to ensure she was diversified. At that time, she didn’t know about the fact sheet that every ETF has and that it’s possible to see a list of the stock holdings in an ETF. It turned out that there were major overlaps, the holdings were basically the same, and she wasn’t diversified as she thought she was.

This story reminded me of one of my first experiences being a speculator. In my mid 20’s I invested in microcredit. I supported small, female businesses in Africa by giving a credit and in return earning a small interest. I knew about diversification, so I invested in multiple African countries and in many different areas of business (delis, hair salons, tailor, agricultural business etc.). To me it was more about contributing to these ladies, rather than getting my money back. 

Overall, it went well - a few loans defaulted but overall money was paid back. Until one day where it turned out that one individual, who was responsible for loan offices in several countries had embezzled and defrauded the microcredit company. My money was gone, and I learned a valuable lesson about diversification. 

My learning is that you must really THINK though several scenarios around an investment. Are you truly diversified? If all your capital is in stocks, or in the same country or region – even continent you’re not diversified. The American stock market impacts stocks and other asset classes (like real estate, currencies, commodities) all over the world. To me diversification is something that requires a lot of thought – will the domino effect of an economic crash impact my assets and how? 

Buying one of the popular ETFs following an index doesn’t reduce your risk. I’m not saying buying ETFs is a bad idea – I’m pointing out, that it’s an illusion to believe that buying one ETF or more will automatically make you diversified. Read the fact sheet and understand the spread. You must know what you’re putting your money into, in order to minimize your risk of losing your hard-earned cash.

Many years later I learned about Warren Buffett’s investing strategy and Buffett is known to go against the general consensus that diversification will reduce your risk. He has said:

"Diversification is protection against ignorance. It makes little sense if you know what you are doing."

What he means is that if you have studied a company in detail before you invest in it, and you know it’s a wonderful business with a strong competitive advantage, robust intrinsic value, and management with integrity, then you’ve reduced your risk significantly. The risk of losing money. 

Because you know that you own a strong business that with withstand a crisis. Yes, the stock price might go down from time to time, but the business is strong and over the years it will grow and your money compound. 

And you can use Buffett’s “wonderful business” idea for other investments too. If you invest in real estate, microloans, SPACs, crypto, forex, crowdfunding etc.: are you investing in something wonderful, with a leading advantage compared to competition, does the thing you’re about to invest in have a durable intrinsic value and does the people around it have integrity?

If you can’t answer the questions or if the answer is no, then it’s a risky investment, and you can potentially lose money. If you change your mindset and think about these key principles before putting your money in anything, then you’ll have a whole other level of certainty and confidence in yourself and your investments.