Rethinking Diversification: Is More Always Better?

We’ve all heard the saying, “Don’t put all your eggs in one basket.” This mantra has been the cornerstone of investment advice for generations. But is more diversification always a good idea? Let’s take a closer look at this widely accepted investment principle and how it may not always be in your best interest.

The truth is, some advisors may prioritize their own financial gain over your best interests. By pushing the idea of diversification, they can promote a variety of investment products, generating more fees and commissions for themselves at your expense. This could lead to an overly complicated and potentially underperforming investment portfolio. “Diversification” has become the ultimate excuse to sell you anything that you don’t already own.

Warren Buffett, the Oracle of Omaha and one of the world’s most successful investors, doesn’t diversify. He has 75% of his portfolio invested in 5 US Large Cap stocks. So why does he go against conventional wisdom? The answer is simple: Warren Buffett’s investment philosophy is centered on the idea of investing in high-quality companies with strong competitive advantages, which he refers to as “economic moats.” By focusing on a small number of these companies, he is able to thoroughly understand their business models, competitive advantages, and growth prospects, allowing him to make informed investment decisions.

Now, this is not to say that diversification is inherently a bad idea. In fact, the rise of financial inventions like index funds and ETFs has made it easier than ever for individual investors to assemble a well-diversified portfolio without professional help. To illustrate this point, let’s look at a simple example of a well-diversified portfolio made up of one equity ETF and one bond ETF:

Equity ETF (e.g., VOO – Vanguard S&P 500 ETF): This fund tracks the performance of the S&P 500 Index, providing exposure to a wide range of large-cap US stocks.

Bond ETF (e.g., BND – Vanguard Total Bond Market ETF): This fund tracks the performance of a broad, market-weighted bond index, offering exposure to a diverse array of investment-grade US bonds.

To create a balanced portfolio, you can adjust the ratio between these two ETFs based on your risk tolerance and growth goals. For instance, if you prefer a more conservative approach, you might allocate 60% to VOO and 40% to BND. Alternatively, if you’re willing to take on more risk in pursuit of higher growth, you could allocate 80% to VOO and 20% to BND. The key takeaway is that it’s possible to achieve an effective level of diversification without overcomplicating your portfolio or falling victim to the trap of over-diversification.