Buffett objected to diversification in 1996 and has since become the most classic comparison between "diversification" and "concentration."。But for the average investor, diversification is often an investment that is often encouraged at the novice stage.

What is Diversification?？What is the purpose？

Diversification is a form of investment that many people use, often on the same principle as "don't put your eggs in the same basket."。

We compare baskets to investments and eggs to assets, and when we accidentally knock over baskets, the eggs inside will break together, which is tantamount to losing our hard-earned investment losses.。

Thus, in order to avoid losing money together, we choose to diversify our investments, and when one of the investments loses money, only the assets of that investment are lost, but the other investments continue to be made.。

This is the most common explanation for diversification.。

Many people will advocate diversification is not without reason, some researchers have found that this is related to the "loss aversion (loss aversion)" this psychological phenomenon, humans are hate loss, so in order to reduce losses, will find ways to solve the loss, diversification is the "loss aversion" under the resulting solution。

How do you understand "loss aversion"?？An explanation can be found first from this example:

Suppose there are 2 situations today:

1.Someone gave you 100 bucks

2.Someone gives you $200 and takes back $100 of it in a while.

The result is the same in both cases: you get $100.。

But feel the mood at the time, which one do you hate more？

Many people's answer will tend to "hate" the second one, because everyone "hates" the loss (loss of $100)。

When this nasty feeling appears, everyone feels somewhat bad, so in order to reduce this situation, start to make some resolution behavior。In the investment world, diversification is the solution to "loss aversion."。

In this way, we can basically understand the principle of diversification, why not put eggs in the same basket, its purpose is to reduce everyone's "loss aversion" psychology.。

Diversified stock portfolio

Diversification is a combination of many investment projects, and of course there are many different combinations, but the common point is to buy different types of assets, such as stocks and bonds are different assets, stocks are divided into different industries of stocks, large stocks, value stocks, etc.; bonds are divided into junk bonds and investment grade bonds and so on.。

Examples of common portfolios for diversification will be given below.

• Stocks and bonds (equity-debt allocation)

Equity bond allocation is the most common way of diversification, as the name implies, the portfolio contains two assets, stocks and bonds, and stocks have greater volatility relative to bonds, so stocks tend to be the largest risk factor in such a portfolio, when the higher the proportion of stocks, the greater the risk, and vice versa.。

For some younger investors, the equity ratio can be enlarged because stocks have higher relative returns but higher risks; for those preparing to retire, it is not appropriate to lower the equity ratio and raise the bond ratio because bonds are more stable relative to stocks。

So for people reaching retirement age, it is recommended not to pursue high-risk investments, at which point it would be better to move the portfolio closer to bonds。

• Stocks in different industries

Stocks can be divided by industry, for example, the S & P 500 is made up of 11 different industries, so it's ideal for diversification。

During the 2008 subprime mortgage crisis, the real estate and financial sectors suffered huge losses, but the extent of losses in the utilities and health industries was not significant, suggesting that investment in different industries can also spread risk。

• Large / small market cap companies

Diversifying your money between large and small cap companies can also diversify your risk, and in general, small cap companies have higher risk and higher returns than more stable large cap companies。

• Investment by market

The geographical location of the investment target is also one of the ways to determine diversification, and in general, the market is divided into three: the United States, developed countries and emerging markets.。Each place (market) has different laws, environments, industries, and different investment models, so that if there is economic turmoil in one market, the other market will not be affected by it, thus spreading the risk.。

• Growth / Value Stocks

Diversification can also be achieved by investing in growth and value stocks, which are also different in nature。

Growth stocks are companies that are growing rapidly in revenue, earnings, and cash flow, and often have higher valuations than the overall market (because of rapid growth); value stocks are companies that have matured and have limited room for improvement, such as the financial sector and utilities, and have relatively low valuations because of slower growth。

Growth stocks, while growing rapidly, are riskier and have higher relative returns, while value stocks have matured, so they are less risky and have lower relative returns, and investing in these two stocks allows value stocks to offset the risk of growth stocks.

• Diversification Real Case: Ray Dalio's All-Weather Portfolio

Ray Dalio, founder of Bridgewater, has a proud portfolio: The All-Weather Portfolio (The All-Weather Portfolio), a portfolio designed to cope with all market changes and strive to perform well in times of economic growth, recession, inflation and deflation.。

The allocation of the all-weather portfolio includes:

investment target	Combination ratio	Tracking targets
TLT	0.4	Tracking U.S. Treasury ETFs Over 20 Years
IEF	0.15	S. Treasury ETF that tracks 7-10 years
DBC	0.075	ETFs that track the 6 most traded and most important commodities (crude oil, thermal fuel, gold, aluminum, corn and wheat)
GLD	0.075	ETFs that track the price of gold
VTI	0.3	An ETF that tracks 3,000 companies in the United States (essentially the same as investing in the entire United States)

As for how the all-weather portfolio is performing？

As can be seen from the following graph from 2013 to early 2023, if you invest $10,000 each in 2013 until early 2023, the all-weather portfolio (blue line) grows by 61 compared to the S & P500 (orange line), respectively..84% and 170.93%, although Ray Dalio slightly lost, but can be found to be more stable, and even the 2020 epidemic has hardly affected portfolio growth, so if you want to reduce the risk to a very low level, you can consider imitating his investment strategy.。

What are the benefits of diversification?？

• Reducing unsystematic risk

Before understanding how diversification reduces unsystematic risk, quickly understand what "systematic risk" and "unsystematic risk" are.

• Systemic risk: an uncontrollable risk, driven by the economy and the market, that affects the overall market environment
• Unsystematic risk: Risks arising from individual companies, where a single event does not affect the overall environment.

For example, when there are only two car companies in the world: H and T。

When the global economy is bad and people don't have the extra money to buy cars, sales of all car companies (H and T) fall and share prices fall accordingly, which is systemic risk。

When there is a problem with H's parts and consumers are afraid to buy H cars and turn to T cars, H's sales will fall and the stock price will fall, but T's sales will rise and the stock price will rise, which is an unsystematic risk。

If we buy both H and T stocks, T will rise even if H falls, so T makes up for H's losses and the unsystematic risk is resolved。

Similarly, diversification is the benefit of investing money in different projects, where losses and profits between different projects are balanced against each other, resulting in a significant reduction in unsystematic risk.。

• Long-term pay is good.

The long-term rewards of diversification are usually positive, and even if the "one up and one down" caused by unsystematic risk makes the asset invisible in the short term, in the long run, the asset has the opportunity to rise.。

For example, the most classic target for diversification: the S & P500, the S & P500 is the 500 largest public company in the United States, with all walks of life in it, so the risk is also very diversified.。

Looking at the historical growth of the S & P500, the average annual payoff rate was 8% over the nearly 60 years from 1957 to 2018, but not every year it grew on an 8% trend, some years it was losing money, some years it was profitable, but lengthening the time reveals that the payoff is growing steadily。

What are the disadvantages of diversification?？

• Decrease in profitability

Diversification has an implicit risk that it will cause earnings to fall, and while the long-term rewards mentioned above are good, that's the most common reward, and the truth is that the company's share price will go up and down.。

Suppose you invest in 10 stocks today, one of which is up more than 100% and the others are holding up, then overall investment performance is up 10%, but if you only invest in that stock that will go up 100%, then the profit is 100%。

For example, Tesla (stock code: TSLA) soared in early 2020, far outperforming the market, and before it joined the S & P500, people who only invested in the S & P500 naturally got less of the pie.。

This downside is exactly why Buffett doesn't support diversification, and here's why he doesn't encourage diversification。

• Unable to take into account all assets

If there are 10 stocks in the portfolio, then investors need to pay attention to the changes of these 10 companies at all times, assuming that most of them are not full-time investors, then the average person can not afford to study these 10 companies, for example, do not have time to study the financial reports of each company, so it will create a dilemma that can not take into account all assets.。

Of course, if you invest in more companies, such as 15, 20, 30, you will only need to know more about the company, which will create a greater burden.。

Therefore, it is recommended to invest in companies that you have the time and ability to understand, or invest directly in the broader market index, follow the trend, will be more labor-saving.。

• Handling fees may be excessive

Diversification has a blind spot that many people won't notice: excessive fees。

When investing in more commodities, the more likely it is to pay more fees, in case the investment profit can not cover the fees, which is tantamount to self-defeating, so fees are also a matter of diversification to pay attention to.。

Concentrated vs. Diversified Investments

Concentrated investment is the opposite of diversification, concentrated investment hopes to select only a few targets, and expect these targets to bring performance beyond the broader market, and diversification of the biggest difference is that as long as the diversification of investment as close to the broader market compensation;。

However, in contrast, concentrated investment also requires more specialized operating techniques, so it is usually the way for professional investors to invest.。

So can concentrated investment bring excess compensation?？In fact, it depends on the investor's stock selection ability, to be honest, the risk of concentrated investment is much greater than diversification, so it is not recommended for ordinary investors (especially novices) to use this method.。

The following are the differences between concentrated and diversified investments.

	Diversification	concentrated investment
Relative Return / Loss	Small	Large
Understanding of the company required	Low	高
Relative risk	Small	Large
Suitable for ethnic groups	Novice, Amateur Investor	Professional investors, full-time investors

In fact, whether it is concentrated investment and diversification, there are their corresponding suitable for the operation of the community, so there is no diversification is necessarily better than the concept of concentrated investment, or concentrated investment is better than diversification.。

If you have weak stock selection ability and no time to study the company, then diversification is naturally the first choice; if you have strong stock selection ability and plenty of time to study the company, then concentration is more suitable for you.。Speaking of which, the next step is to bring to Buffett's view of diversification, which just echoes the essence of both investment methods。

Buffett's view on diversification

Buffett in 1996's Polkshire.At Hathaway's annual general meeting, he mentioned his views on "diversification," when he was interviewed by reporters who asked him what his principles were for diversification and concentration.。

Buffett believes that diversification is meaningless to people who really know how to invest, is a protection against ignorance, and they want to make sure that their portfolios are not affected by market fluctuations, because it's safer for people who don't know how to analyze a company.。

But assuming you know how to analyze and study a company, there's no need to invest in 50, 40, or even 30 companies, for example, you have a ranking of quality companies in your hand, but invest your money in the 30 companies instead of the number one, or spread it evenly among the 30 companies, and don't invest a little more money in the number one company, which seems stupid, right？

So diversification is important for Buffett and his partner Charlie..Monge, are bad operations, perhaps for the average person to diversify the mediocre performance has been able to satisfy themselves, but in Buffett's eyes, diversification means that investors do not understand the company's business model。

Buffett further mentioned that in Poxha.Heatherville, even if he invested all his money in three stocks he knew perfectly well, he would be so happy that he even felt that his life was enough。Buffett believes that a good company can cope well with market changes and competition, and Coca-Cola is his proudest example。

Of course, if he can find more companies like Coca-Cola, he will also "spread" his money there, but it is not so easy to find, and even think that investing in only a few good companies is much less risky than diversifying.。

It seems that Buffett actually does not encourage diversification, but advocates concentrated investment, but after all, we are not Buffett, everyone has the most suitable way to invest, so when to diversify, when to concentrate, for the average person how to choose, please see the next paragraph.。

When to Diversify？When to focus on investing?？

Most people choose to invest in trading, in order to allow themselves to have a surplus income outside the main business, but the lack of time and stock selection strategy is not as good as professional investors, perhaps this time to choose "diversification" is better.。

And a small number of people have strong stock selection ability, or are full-time investors themselves, this time choose "concentrated investment" will be better than diversification.。

So when to diversify and when to concentrate, it really depends on the investor's ability to pick stocks。More conservative diversification for poor stock selection; more aggressive concentration for strong stock selection。

SUMMARY

After reading the above, you have learned the essence of diversification, a brief summary:

The purpose of diversification is to avoid loss aversion, and putting eggs (funds) in different baskets (investment targets) has the advantages of reducing unsystematic risk and stable long-term returns, but the disadvantages are the risk of missing out on greater profits, failing to take care of all targets, and incurring excessive fees.。

The opposite is concentrated investing, which is what Buffett advocates: investing in only a few stocks and expecting them to outperform the broader market.。However, the professional threshold of concentrated investment is higher, which is not suitable for most people to use, so if the stock selection ability is not good or want to reduce the risk of investors, it is recommended to use diversification, on the contrary, the stock selection ability of good talent to use concentrated investment.。