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The Importance of Diversifying Your Portfolio

Most people have heard the phrase “Don’t put all your eggs in one basket.” When it comes to investing, the meaning is clear: Don’t concentrate your portfolio in a few stocks, sectors, or countries.

Stanley Druckenmiller disagrees with this notion. While he’s not a household name, Druckenmiller is a legendary money manager in the investment world. Over a 30-year period, his hedge fund averaged annual returns of 30% without a single down year. This may be the best long-term investing track record of any investor on the planet.

Interestingly, Druckenmiller attributes his success not to diversification, but the very opposite of it. Here’s how he explained his philosophy in a speech last year:

“I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it.”

So should the average investor heavily concentrate his or her portfolio in a few stocks or sectors?

No.

For one thing, there are many, many times when someone takes a huge gamble on a single investment and it doesn’t pay off. The problem is we often don’t hear about these failures because the people involved understandably don’t talk about them.

In addition, there’s a difference between someone like Druckenmiller and the average investor. He is an expert investor and has managed money for decades. Whereas for most investors, it’s not their day job or area of expertise. If you’re going to take a huge bet on a particular stock (which is very risky), you shouldn’t do so unless you’ve really done your homework and you’re prepared to lose big.

Diversification isn’t exciting. It won’t lead to the kind of massive returns that someone like Druckenmiller enjoyed. But it will let you sleep at night and help protect your portfolio.

The basic argument in favour of diversification rests on the assumption that an investor can’t know with any certainty what type of asset (stocks, bonds or fixed income, or cash) is best to own at any particular time. As a result, it’s useful to have exposure to a number of different assets (GICs and high-interest savings accounts are considered fixed income and cash, respectively). That way, if one part of your portfolio falls, another may rise to offset it. Furthermore, spreading your money among different investments reduces the volatility of the whole portfolio because it’s not moving up and down based on one or two components.

For what it’s worth, there’s a case to be made for concentrated investments. If someone is an active investor with a lot of expertise, they may wish to ignore some sectors in favour of those they really think will do well. While no one knows what the market will do, there are investors who can achieve consistently above-average returns.

Unfortunately, this isn’t something a typical individual has either the time or expertise to do. So rather than putting all your eggs in one basket, it’s better to spread out risk and enjoy decent returns instead.

However, it’s crucial to be diversified in stocks. For Canadian investors, here’s a good example of what that means. There are 234 stocks in the S&P/TSX Composite Index. Someone who owns an exchange-traded fund (ETF) that tracks the index is clearly diversified, right?

Wrong. Financial companies (banks and insurance) and the resource sector comprise nearly 70% of the TSX. If those two sectors take a hit, the index will fall. Yes, there are many different stocks but they often move in tandem with each other.

This is an argument is favour of having international exposure in your portfolio but again, look under the hood. Say you decide to buy an ETF tied to the Australian stock market to diversify your portfolio. But are you really diversified? Australia’s economy and stock market is very similar to Canada’s, with a high concentration in resources and financial firms. As a result, the Canadian and Australian markets often move more or less together.

Meaningful diversification involves owning different types of assets and having exposure to different countries and sectors. It lowers the risk of having one bad investment devastating your portfolio.

You may not become the next Stanley Druckenmiller but you won’t lose everything, either.

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Flickr: Iman Mosaad