It’s sometimes hard to know the provenance of investing’s best known sayings, but the excellent term “diworsification” is usually credited to Peter Lynch. In his 1989 book One Up on Wall Street the ex-Fidelity fund manager made it clear that the wrong kind of diversification was a bad thing.

In context, Lynch was talking about the problem of companies that spread themselves too thinly. He preferred simplicity. He didn’t like firms that maxed out their time, energy and resources on non-core activities, often for depleting returns.

In the years since then, diworsification has come to mean much more to investors - but the spirit is still the same. These days it refers just as much to diversification in an equity portfolio as it does to company activities. And it’s a term that often crops up when commentators talk about risk. You see examples in articles from legends like the late Jim Slater to the present day investing great, Terry Smith.

With the end of the tax year in sight, it’s reasonable to think that many investors are reviewing their portfolio holdings. So this this week I’m exploring some of the issues around diversification and ways to think about spreading exposure in a portfolio.  

Diversification 101

As a subject, diversification divides opinion. Modern portfolio theory (MPT) argues that portfolio risk can be adjusted by diversifying across a higher number of stocks. That tallies with the general message from the finance industry.

Yet, even a brief look at some of the strategies of great investors suggests that smaller, high conviction portfolios are sometimes preferable. Warren Buffett, the famously successful investor, once remarked that: “Diversification is a hedge for ignorance. It makes little sense for those who know what they're doing.”

So how can these two perspective be reconciled? The answer, according to some research, is that most investors should diversify more. But there’s also a subset that can get away with smaller numbers of holdings because they genuinely have an edge.

This was the finding of a well known study that examined the diversification choices of 60,000 individual investors at a U.S. brokerage over a six year period in the 1990s. Importantly it looked at the covariance, or correlation, structures of those portfolios to assess diversification on two levels: A) the risk reduction due to holding more than one security, and B) the…

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