Persuasive Paper Against Portfolio Diversification

Diversification, Schmiversification

Steve Smith, 23, recently out of college, has just won $15 million in the lottery. After buying a few things, he realizes that he still has quite a bit of money, and starts to look at the big picture and what he should do. After his girlfriend shoots down his dreams of buying an island paradise where he could relax and golf all day, or buying his own rocket ship, Steve is forced to think of more practical things to do with his newly acquired fortune. Unable to find a way to spend it all, Steve decides to save and invest most of his winnings. He begins searching financial magazines and the internet for the best way to build his capital.

Steve faces an issue that many investors today face--not a pessimistic girlfriend, but rather how he should invest his money. In his research, Steve has found that there is a commonly accepted investment style that is focused on diversification of risk. Risk in terms of investing is based on the possibility of losing your money. For example, stocks are higher-risk investments where government bonds are considered lower risk, because stocks are shares of ownership to a certain company, which could see hardships at any given time, while government bonds are guaranteed by the country's treasury to ensure that the investor is paid when the bond is due.

While he was doing all this searching, Steve remembered the time he was going to a Hawaiian party in college, and his searching for clothing ideas from his idol, Jimmy Buffett. In his online search, he came across some other Buffett, named Warren, who he remembers be deemed some "investment guru." Before he decides to do anything with his cash, Steve decides to see if this Warren guy is the best in his field, just like Jimmy. Come to find out, he is. Warren Buffett, currently the second richest man alive and CEO of mutual fund company Berkshire Hathaway, owes almost all of his overbearing bank account to personal investments. Buffett is not, however, a traditionalist when it comes to his style of investing; he is a man who does not believe in diversification.

The "traditional" portfolio technique, or so to call it, teaches investors to diversify their risks--simply, to have a balance of stocks, bonds, and other investments that are of varying risk. The logic is that being too heavily invested in stocks could do great harm to an investor if the stock market goes through a tough period; the same is true for less risky ventures: being too heavily invested in bonds will not cost the investor any money, but bonds do not have the potential to show the returns that stocks can.

Trusted investing information companies, MorningStar and Bloomberg, both present subscribers with an education on investing. In Investing 101: Getting a Good Start with a Sound Strategy, Bloomberg says that diversification "helps preserve your portfolio's value, mainly because some investments rise while others fall." Their motivation in saying this is that unforeseeable circumstances can alter performance within and across industries. If an investor's portfolio was heavily allocated in one stock or industry, poor performance could really hurt the status of the portfolio. Similarly, being diversified can help investors to "capitalize on unforeseeable growth" of a stock or industry and thus increase their portfolio's value. MorningStar's educational series gives the same premises for diversification and goes on to say that diversification can create the most "efficient portfolio."

Warren Buffett does not agree with conventionally diversifying a portfolio, because he feels it does not truly reduce risk. He has gone so far as to say, "risk comes from not knowing what you are doing" (Investopedia.com). Buffett's own portfolio consists mainly of the same stock holdings as his company's, Berkshire Hathaway, mutual fund portfolio. His technique is to invest in the stocks of companies that he feels will still be going strong twenty years from now. Buffett looks at the value of a company, which he measures in terms of current performance, some fundamental of the financial statements, and his personal speculation on the company's future performance. His lack of diversification is a strong contrast to that of the traditional method; however, this lack of diversification has helped his personal portfolio to outperform market indexes, used as benchmarks for returns on stock market investments, such as the Dow Jones Industrial, the Nasdaq, and the Standard and Poor's 500 (S & P 500) every year for the past 40 years.

In his article "Warren Buffett: The World's Greatest Investor," financial journalist Maynard Patton presents some quotes from Warren Buffett on his investment style. Buffett is attributed with saying "conventional diversification makes no sense for [a know-something investor]. It is apt simply to hurt your results and increase your risk." Buffett's rationale is that investors should not buy shares of a stock unless they feel the company they are buying into will be around for a while. To make an assumption that a particular company will still be a functioning body in the future would require some knowledge of the company's financial situation and the industry in which it operates. Essentially, Buffett believes that people should only invest in companies with which they are familiar. Along these lines, one of his strongholds is that many people purchase stocks of companies in industries with which they are not familiar for the sake of diversification. Making a less informed choice, to Buffett, is much worse than not diversifying a portfolio.

While their methods differ in terms of how many stocks and which industries to invest in, both Buffett and the "traditional" method have the same aim for portfolios: safety. Buffett's intuition is that an investor is taking less chances by investing in a company in a familiar industry, where Bloomberg's idea of security entails covering all possible bases in light of possible good or bad. Diversification does fundamentally make sense because it helps investors to cover all their bases, but it does have its downfalls. In diversifying their portfolios, investors are often rolling the dice with their money by choosing stocks of unfamiliar companies in unfamiliar industries for the sake of diversifying their investments. Making uniformed choices can be quite dangerous, and in my opinion, and that of Warren Buffett, diversifying a portfolio by means of purchasing unfamiliar companies' stocks is not a good move.

This is not to say that Buffett's style is flawless. As the traditional method points out, being heavily invested in