When in doubt, diversify. That’s the underlying logic behind diversifying your stock portfolio, the number and types of businesses in your company, and often drives feature development in products. Diversification is often an implicit admission of failure to understand the fundamentals of something and signals a lack of conviction.
Diversification is a strategy to regress to the mean. It’s a strategy where victory is being average. How many students dream of being a ‘C’ student? How many investors dream of average returns? How many startups dream of being average? The notion of regression comes from Sir Francis Galton’s publication of Regression Towards Mediocrity in Hereditary Structure. Over time regression towards mediocrity came to be known as regression to the mean. I prefer the original description. Diversification usually leads to mediocrity.
“Put all of your eggs in one basket and guard that basket.”
Do your homework, have conviction, and take a stand. It’s the right way to build a product, to build a company, and to be an exceptional investor. Clearly even focused investors make a few bets — you can make 1-2 very well investigated bets per year. Can you really make 20 bets per year per person and come out a winner year after year? Great entrepreneurs iterate, but my experience with great entrepreneurs is that there is usually an ethos and sense of clarity behind what they are trying to accomplish. It’s not about tossing spaghetti at the wall.
1. Focus increases your ability to understand what matters.
The problem with diversification is that the effort required to master something is so great that every spare neuron spent on something else gives the person with focus an upper hand. Diversification is attractive not because it works, but because it requires little effort.
Warren Buffet and *all* of the best investors I know favor making a few very well informed bets rather than opting for significant diversification. Diversification strategies like funds of funds are responsible for allowing Bernie Madoff to exist. Good limited partners (LPs) do a great deal of work to pick a relatively small number of investment vehicles. This allows for significant research before and oversight after an investment [both of which would have quickly uncovered Madoff's scam]. Good LPs put their money behind investors who do the same — make a small number of well informed and actively managed bets. Good VCs put their money behind entrepreneurs who have a point of view, domain expertise, and conviction to realize the impossible.
Focus is not inconsistent with intellectual honesty. It does not mean ignoring feedback. It simply means that your bets are well selected and that your conviction to find a way to make something work is high enough to overcome the inevitable hurdles of building a company, product, or investment portfolio.
2. Focus forces brutal prioritization.
When you get to make a small number of bets, it forces continuous prioritization. It’s extremely hard to measure the value of something against some abstract and absolute notion of value. It’s much easier to say, “I get one bet, so is A better than B and C?”
The fact that you get to make few bets also increases the stakes. Proponents of diversification argue that it takes the edge off of making a mistake. That would be a good argument if people acted the same way independent of their ownership in an outcome. But human beings do alter their behavior based on how much skin they have in the game. When costs and benefits are divided amongst too many, accountability is lost. Excessive diversification makes participants passive, dependent on the actions of others who are dependent on the actions of others, and so on. A free rider at best and a sucker at worst.
3. Focus brings clarity.
While everyone else is chasing diversification, those who make a few well placed bets learn at a faster pace. They have clarity on what matters in an investment, company, or product. This clarity attracts others and makes things clear for them, too.
When Steve Jobs took over Apple again in the late 1990’s, he first pruned the organizational ranks. He then pruned Apple’s product line down from many to just four. He communicated Apple’s culture to employees, partners, and customers with the Think Different campaign. It was only years later that Apple brought forth the iPod and later the iPhone. Great leaders make things clear to everyone — it’s more about tossing out the excess rather than adding new ideas and projects to the roadmap.
Making fewer bets requires conviction. It requires the courage to stay the course. And it requires the support and resources to take the long view. If you do these things odds are that you will do something worthwhile. Wouldn’t you rather aim for the ninth decile rather than the mean?
15 responses so far ↓
Michael F. Martin // May 8, 2009 at 10:11 pm |
Great post, as usual. I think about this in terms of the central limit theorem, but it’s the same thing.
There is a very important caveat here for extremely smart people:
Diversification is often an implicit admission of failure to understand the fundamentals of something…
…better than the next guy! This is really important to remember. You don’t have to know everything. You just have to know it better than the next guy.
Steven Carpenter // May 9, 2009 at 1:16 am |
I look forward to your posts, Mike, because they always force me to think and reconsider previously held assumptions. Always well done and considered. Thnak you.
I think this week’s installment holds up well, particularly from an entrepreneur’s and venture capitalists perspective. In fact, you can make the case that focus and fear of failure and alternatives are the main drivers of entrepreneurial success. True entrepeneurs BELIEVE or HAVE TO believe, and due to the constraints of time and resources, are better off working on one project versus spreading their attention too thin as to diversity their passion to different opportunities. In this regard, an entrepreneur or investor has assymetric information that gives him or her an unfair advantage vis-a-vis the market. It is a smart bet because the players know something or have something others don’t.
Having said that, I think the framework breaks down when it comes to public markets, especially with regard to asset allocation and diversification. Information assymetry disappears (for the most part) and the ability for that individual to take a proactively effect his or her investments is neutered.
Buffett does indeed take large, isolated bets but when you look across his portfolio he is fairly diversified. Insurance, candy, furniture, financial services, beverages, etc. gives him a variety of exposures across industries. Is he perfectly optimized? I don’t know. But he does have an investment thesis and he does consider his entire portfolio when making those decisions.
When it comes to individual investing, research shows that focused bets is not a long-term, winning strategy. Most mutual fund investors and professional money managers fail to beat the markets, as does the “average” investor. In public market investing one loses the ability to control one’s destiny, where the characteristics you so correctly surface actually matter. Much better to have a thoughtful long-term strategy that both preserves weath and smartly participates in the upside.
Hope you are doing this. For the sake of the kids!
jolly // May 9, 2009 at 4:28 am |
Warren Buffet-isms:
“Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”
“Diversification may preserve wealth, but concentration builds wealth.”
“Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By
periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.”
Mike Speiser // May 9, 2009 at 4:42 am |
Love those quotes Jolly; particularly the first one:
“Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”
And I agree that if you want diversification, buy an index fund. At least the fees will be reasonable and you’ll actually have a shot of being average.
Another strategy is to buy U.S. Treasuries for the wealth you want to preserve and concentrate the rest in a few well researched bets. That’s diversification that makes sense to me.
Steven, remember that Buffet made his fortune investing in public stocks and that he had no control over those companies until much later in his career. The difference between Buffet and others is both his research / stock picking skills *and* the courage he has to believe in himself.
It has taken me quite some time to cleanse my brain of the efficient market hypothesis and the like. Nothing like overwhelming evidence to correct a wrongly held belief, eh?
David Sturtz // May 9, 2009 at 8:35 am |
Good stuff Mike. Your follow-up on how one might invest the wealth they want to preserve in t-bills is an excellent point I rarely see made. And it suggests to me a method for investing your time and assets as you live your life over time: concentrate your focus on high growth opportunities when you want to go fast (accumulate wealth), shift your focus to safe/stable assets when you want to relax (preserve wealth), and allocate between the two as your time/energy permits. When viewed in that manner, you’d never consider the type of diversification that’s become common parlance in our investing lexicon. (This is something I thought about frequently when I ran my hedge fund).
Keep up the great posts.
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shravan // May 11, 2009 at 3:18 am |
Excellent post – as always! Keep ‘em coming Mike
Hanif // May 13, 2009 at 5:04 am |
Great piece Mike but here’s a ‘what if’ question … Say u have a special coin with a 70% chance of landing heads and I give u a choice:
- bet $1 million on the next throw, or
- bet $100K across 10 throws
Which would u pick? As a lifelong investor/arbitrageur I would surely diversify across 10 throws to reduce the effects of “bad luck” even though I knew I was playing “a winning game” where I possess an edge. Of course the odds of a max $1mm profit would also diminish but I am all about making healthy, consistent profits over the long run.
I get what u are saying for entrepreneurs: hard to find & focus on 10 great business ideas. But as a mainly passive investor, I always believe good research/insight merely skews my odds but never entirely eliminates downside risks. So I try to find as many investments with “tilted” risk/rewards (i.e.70% coins) and let the power of the math work for me.
Does that make me mediocre?
Mike Speiser // May 13, 2009 at 6:28 am |
Hanif, thank you for your comment. You are one of the best investors I know, so my response is with all due respect.
If an investor makes 1-2 bets per year and holds for the long term, he can reach 10 bets in 5-10 years. If my argument came across as a recommendation to make one bet ever as an investor, that was not my intention. So we are not talking about 1 bet versus 10, but rather 10 versus 30, 50, 100 or possibly even more over the course of a decade.
Your hypothetical coin example implicity assumes that the odds are the same for 1, 10, or presumably an infinite number of tosses of the coin. My belief is that you can considerably improve your odds by doing fundamental research — that the efficient market hypothesis is misguided. Sure you can reduce some risks by diversification, but you take on new risks through ignorance of a firm’s fundamentals. So it’s not about having the courage to roll the dice as you suggest, but rather the wisdom to understand that you are doing exactly that with significant diversification. Back to your example — I would argue that the odds of landing heads regresses to the mean (50%) with respect to the number of tosses. So the cost of buying additional throws in your hypothetical example is lower odds per toss as our 70% advantage disappears.
All investments ultimately come down to a firm’s ability to generate cash. You cannot reasonably assess the cash generative capacity of a firm without having a deep appreciation for the fundamental details about the firm, an understanding of the product markets it plays in, the competitive landscape, and the relationships the firm has with suppliers and customers. You cannot rely on others to do this work for you — you must use logic and the powers of observation to make these judgements on your own. This takes a great deal of time and effort.
If an investor doesn’t have the time or the expertise to do this sort of work, then he should buy an index fund, purchase of U.S. Treasuries, or perhaps make an investment in Berkshire Hathaway. Having said that, there are too many “professional” investors earning mediocre returns and collecting hefty fees for their effort based on wrong-head assumptions about diversification being a free lunch.
I know that you’re not one of them.
Josh Jacobson // May 14, 2009 at 1:52 am |
Great post Mike, and a welcome reminder to stay focused at a startup and cut the BS.
Actually I’ve been thinking a lot about the role of “R&D” lately and was wondering if you had any thoughts on its role at a startup vs a large company.
Joe Russell // May 14, 2009 at 5:59 pm |
Great post and good comments.
It makes me wonder how this idea applies to investing vs. innovation? I think this idea applies to each differently and depends on the situation. But the one principal still holds, if you know what you are doing, diversification isn’t necessarily the best strategy.
Great stuff!
Justin // May 15, 2009 at 6:27 pm |
I always felt that diversification is a risk aversion strategy for managers of “other peoples” money. Their goal is fee generation which requires the customer to stick around. Failing bets burn their book while median mediocrity keeps customers around to try again next year. So when a broker tells someone to diversify their portfolio what they are really saying is “don’t make a bad bet that loses me a customer”
Greg Abovsky // June 24, 2009 at 4:35 pm |
The other point I would make is that you also have to think about portfolio concentration (I think Hanif alludes to it) – would you put 100% of your net worth into 1 investment? Or would you rather make 1 investment a year that represents 10% of your net worth?
Ken // September 13, 2009 at 5:42 pm |
diversification regarding money should be left
to expert’s, diversification regarding conversations
should be converted into specialties.