Decades of academic research has found that diversification can slash the risk of portfolio wipeouts. But there is also evidence to suggest that diversification is overrated and encourages investors to aim for ‘average’ returns. Warren Buffett described it as “protection against ignorance”, and other famous investors like Joel Greenblatt, William O’Neill and Gerald Loeb tend to agree. Instead, these stock market hunters confidently place big bets on a smaller number of stocks by relying on strict rules and detailed company knowledge. So who should use this approach?
Academics and investors disagree
Before looking closer at focus investors, it’s worth noting why academics and some investing professionals have fallen out over the issue of diversification.
Back in in the early 1950s American economist Harry Markowitz figured out a way of creating an optimal share portfolio. Rather than just buying popular stocks, which was common at the time, Markowitz examined the relationship between risk and expected returns. His model - which he called the efficient frontier - found that it was important to diversify across uncorrelated assets. This tied-in nicely (and in many ways relied on) a theory that emerged later on called the efficient market hypothesis.
Markowitz’s work was the basis of what’s now known as modern portfolio theory and it earned him a Nobel Prize for Economics. But others had their doubts. The theories were criticised for making the erroneous assumptions that markets are perfectly efficient and that investors behave rationally.
Indeed, Buffett has been a vociferous critic. He once said: “I’d be a bum on the street with a tin cup if the markets were always efficient.” In his 1993 letter to Berkshire Hathaway shareholders he rejected ‘diversification dogma’ and insisted that portfolio concentration may well decrease risk if it makes an investor think harder about a business before buying into it.
Super investors use concentration
Buffett isn’t alone with this opinion. Some of the world’s best known investors have made fortunes from concentrated portfolios of stocks they understand well. Among them is US fund manager Joel Greenblatt, who wrote The Little Book That Beats the Market. He says that short-term thinking and overly complicated statistics can make it feel safer to own many companies that you know very little about rather than owning stakes in five to eight companies that have good businesses, predictable futures and bargain prices. He notes:
“For the few who have the ability, knowledge, and time to predict…
