Some investment experts advocate maximum diversification, which others deride it as “di-worse-ification.” In Ben Carlson’s recent article, he is somewhere in the middle saying you need to find the “right balance between eliminating unsystematic risk (risk that’s specific to single securities or industries) and di-worsification by adding too many overlapping funds.” Who is right? Your answer depends on your views on active investing.
At one extreme, suppose you knew for certain you’ve identified the one stock that will go up most in the next year. You’re not 90% sure or 99%. You’re 100% sure. Then you’d be crazy not to invest everything you have in that one stock. Of course, you’d also have to be crazy to be this certain about the stock.
As our crystal balls become cloudier, the need to diversify arises. Maybe you decide to put some of your money into other stocks, even though you have less confidence in these other stocks. You’ve decided that the protection against possibly being wrong about your top pick is worth the risk that your lesser picks will make less money.
Those who argue that you’re di-worse-ifying are saying that you’re diluting the potential returns from your top pick with lesser ideas. How far it makes sense to go with diversifying depends on how confident you are that your top stock picks will work out well.
At the low end of the confidence continuum, we have those who have no idea which stocks will perform well, have no idea if markets are going to go up or down, have no idea which money manager will perform well, and have no idea which financial advisor might beat the markets for us. These people are indexers.
Diversification is simple for indexers like me. We own all stocks for as low a cost as possible. There is no such thing as di-worse-ification because we have no opinions about one stock being better than others. There is no reason to fret over active mutual funds because index funds are cheaper and cover the same asset classes.
Another thing to consider when it comes to diversification is that all evidence points to very few people having stock-picking skill. Even among money managers you might choose to manage your money, very few have enough stock-picking skill to make up for their fees and expenses. And very few individual investors have the skill to identify these winning money managers.
So, almost everyone who thinks they can beat the market either with their own picks or by finding the right helper is wrong. Not everyone, but almost everyone. I had the stock-picking bug for about 12 years, but a careful study of my results beat that nonsense out of me. I’m a happy, diversified indexer now.