The only “free lunch” for investors, according to some.
A tool for the uninformed, according to others.
I’m not here to argue it either way – I’m personally in the camp of the former – because I’ve already made my mind up and invest accordingly.
What other people decide to do is up to them.
Everyone has their own risk tolerance and views on diversification.
People should always invest as they see fit.
So I’m not writing this article in order to in any way convince anyone of any level of diversification, nor will I be delving into the historical numbers that prove out why diversification is so important and worthwhile. I’ve already put together content like that over the years, so I don’t want to retread old ground.
I’m instead putting this piece together to have a conversation on some of the rationale behind the broad diversification of my own portfolio.
Specifically, I want to speak on a concept that detractors of diversification sometimes point to.
That concept is “diworsification”.
A term popularized by the great Peter Lynch, it’s a play on the word diversification that refers to diversifying to the point of worsening your portfolio.
An example would be to go after low-quality/high-risk investments simply to diversify.
One shouldn’t ever diversify purely for the sake of diversification.
Obtaining a new investment that reduces the risk/return ratio of your portfolio is diworsification.
Sometimes this is only seen in hindsight, but it should always be avoided when it’s clearly present.
I actually read about some so-called dividend growth investors jumping on the Bitcoin craze a while back. That would be, in my view, a prime example of diworsification. Throw in a great deal of speculation on top of it.
Diversification should be used to spread and reduce risk. That’s it. It’s risk management. Used appropriately, it can allow you to get maximum return at minimal risk.
Of course, what’s “appropriate” will vary according to one’s own risk tolerance.
There are few successful investors who have either argued against diversification or have invested in a heavily concentrated manner over a very long period of time.
Even Peter Lynch (one of the greatest stock investors of all time) managed over 1,000 positions in the Magellan Fund toward the end of his run with Fidelity. So he clearly saw the benefits of diversification, but he also strongly diversified in a way that didn’t outwardly worsen his portfolio or performance. (Do as I say, not as I do.)
Diversification is important because significant concentration carries a lot of risk. One unforeseen event could wipe you out if you’re too concentrated. It could at least severely affect your wealth, income, and overall outcome in life.
Diversification might be the only “free lunch” out there because it offers significant benefits without significant benefits. It has a very favorable risk/reward relationship when used intelligently.
As Peter Lynch obviously saw and experienced firsthand, there are a lot more than just a few extremely high-quality businesses in the world. As such, there’s absolutely no need to concentrate too strongly into just a handful of companies.
Indeed, as I’ve noted before, one of the main benefits of investing in the S&P 500 is the broad diversification it offers. You’re investing across ~500 companies. Not all businesses are created equal. Not all of them are fantastic. But there’s surely more than just ten out of the 500 that are doing very well at any given time. And when some businesses aren’t doing well, others probably will be performing better. That’s just the way the economy generally works. Not everything is humming in sync at all times.
With all that said, I think diworsification is a terrible idea.
Just like there’s no need to strongly concentrate oneself, there’s also no need to diworsify oneself.
My FIRE Fund is spread out across 115 world-class businesses.
Every single company in the Fund is paying me dividends. And the vast majority have lengthy track records of routinely increasing their dividends year in and year out. That’s because these companies are adept at increasing their profit over long periods of time.
I’m broadly diversified across business models, industries, geography, etc.
I’m also set to collect almost $13,500 in dividends over the next 12 months.
If one, two, or even three of these companies were to cut or eliminate their dividends, however, I’d be okay. My lifestyle would carry on as it does. Dividends are, after all, almost always “in the green”.
The dividend increases from the remaining 110+ companies would quickly make up for the lost income from the cuts or eliminations.
Knowing that I’m going to be okay even if a world-class business or two runs into severe problems helps me sleep well at night. I sleep like a baby.
And since I don’t see my level of diversification (which trails the S&P 500) as anything close to worsening my portfolio, it’s a no-brainer.
Concentrating into just 20 or 30 stocks (or less), though, would have me sleeping a lot less soundly.
In that case, a few adverse dividend changes could potentially create some lifestyle challenges. Especially if the same 2-3 stocks were in both samples (which is certainly possible). Since it’s not less expensive or less difficult to construct my portfolio in this way, there’s no reason to do it.
My Definition Of Diworsification
I’ll tell you how I personally define “diworsification”.
This is coming from the perspective of someone who’s been a dividend growth investor for almost a decade now. I’ve successfully invested my way into FIRE at just 33 years old, so I’d say it’s worked out great.
I’m going to define this term within the universe of dividend growth investing (ignoring the aforementioned likes of Bitcoin). I’m talking purely stocks here.
I get emails all the time about the portfolio. One email might go along the lines of asking me why I don’t yet own Stock X, Y, or Z. The very next email will ask me why I own so many stocks. It’s actually quite amusing.
Nonetheless, I hope this article will serve to better clarify my stance on all of this.
I mentally separate diversification and diworsification through one simple question before taking on any new investment:
“Would I be comfortable owning this entire business?”
If I wouldn’t be happy with owning the entirety of the business, if I absolutely had to, I shouldn’t be happy owning even just one share.
I can tell you that I would be comfortable with only owning the entirety of any one single business in my portfolio – if I absolutely had to.
But since I don’t have to, I don’t see any reason to invest like that.
I remember investing in The Coca-Cola Co. (KO) way back in 2010.
I felt so happy acquiring shares in the world’s largest non-alcoholic beverage company. When someone bought a can of Coca-Cola or a bottle of Dasani water, I was earning a small portion of money from that transaction. Still gives me warm and fuzzy feelings to this day.
If you would have told me I had to own only shares in Coca-Cola, I wouldn’t have been uncomfortable with that idea. But I don’t have to. And there’s no reason to invest that way.
Likewise, I remember acquiring shares in PepsiCo, Inc. (PEP) shortly thereafter.
I felt extremely happy about this purchase, too. It was a beverage giant in its own right. But I was more excited about the snacks business, which they’ve been dominating for a very long time now. When people are munching on Doritos, I’m cashing dividend checks. A nice calorie-free snack for me!
If you would have told me I had to only own stock in PepsiCo, I could do that. Again, though, I don’t have to. And there’s no reason to be that concentrated.
This line of thought scales way up. That’s because there are hundreds of high-quality dividend growth stocks out there. To force oneself to ride it out with a few is, in my opinion, nonsensical. It’s taking on unnecessary risk for no apparent reward.
It’s up to each individual to find the appropriate amount of diversification across their investments. That’s a personal choice.
Of course, diworsification should always be avoided.
If I wouldn’t be happy theoretically owning the entirety of a particular business, then buying a single share of that business would be diworsification to me.
I’ve found that the question proposed earlier has helped me avoid diworsification, while simultaneously building a broadly diversified collection of some of the best businesses in the world.
“Would I be comfortable owning this entire business?”
And I believe that asking myself this question before any investment will continue to aid me in the future as I go about acquiring shares in businesses I don’t yet own a slice of.
Full disclosure: I’m long all aforementioned stocks.
What do you think? Is this a good question to ask oneself to avoid diworsification?
Thanks for reading.
Image courtesy of: Stuart Miles at FreeDigitalPhotos.net.
P.S. If you’re interested in building a diversified portfolio on your way to becoming financially independent, check out some amazing tools and services I’ve personally used on my way to becoming financially free at 33!