Your Investment Approach: Diversification vs. Concentration

You’ve heard the common phrase, “don’t put all your eggs in one basket.” 

And when it comes to investing, it refers to the concept of diversification. 

As we continue our series on how to build your own investment approach (and why you need to), we have to talk about diversification vs. concentration. Most people hear about the positives of a diversified portfolio.

But not everyone feels that way. 

Some people choose a concentrated approach instead and see diversification as a bad choice.

To understand why this is and how to choose an option that’s best for you, I talked about diversification vs. concentration in episode 68 of The Canadian Money Roadmap. Here’s the run-down so you can make an educated choice for your own portfolio. 

What is Diversification? 

Diversification is an investment strategy in which you hold a broad portfolio of stocks, bonds, or other securities. You can be diversified based on: 

• Types of securities (i.e., stocks, bonds, ETFs, mutual funds)

• Industry sector

• Location

• Market cap size

A diversified portfolio often aims to invest in the market as a whole. Instead of narrowing in on a few companies, you take a cross-section of the entire stock market. 

In doing so, you shelter yourself from the economic failures of any one company. 

What is Concentration? 

A concentrated investment portfolio is when you focus very narrowly and invest your money in just one or a few companies, stocks, securities, etc. 

The goal of a concentrated portfolio is to pick the “winners” instead of buying the whole market. And the reason to do this is to try and outperform the stock market as a whole and receive above-average returns. 

Both Warren Buffett and Mark Cuban—both extremely wealthy and successful individuals—have publicly spoken out against diversification as a strategy. In fact, they’ve even called diversification “ignorant” and “for idiots.”

Their rationale against diversification is that it’s possible to know and pick “winners” to invest in. And, if you can do so, why would you invest anywhere else? 

Diversification vs. Concentration: Evaluating Pros and Cons

Buffett and Cuban are both seriously successful in building wealth. So you may think their approach is the right one. 

But here’s the thing—it may be the right approach in their world, but it’s not the same world as the average everyday person lives in. Both men have an incredible amount of money to play with and work hard to try and outperform the market. 

This strategy doesn’t work for most people. 

For one, the average investor doesn’t have highly specialized knowledge that helps them pick winners. Secondly, the average investor is not in a financial position to risk losing a lot of money based on the wrong choice.

By having a highly concentrated portfolio with just a few individual stocks, you expose yourself to a high level of risk for those specific companies. 

Let’s look at an example.

Say you invested 100% in FTX, a cryptocurrency company that went bankrupt in 2022. By concentrating completely on this company, you’d lose everything. 

But say you added in just one other company, such as Coca-Cola, a stable and well-performing company. If you diversify your portfolio to go 50:50 to each company, even if FTX goes bankrupt, you only lose half. 

The more companies you add—the more diversified your portfolio—the less risk you have because of a singular catastrophic incident with one company. 

You can also diversify in other ways beyond companies: 

• Sectors: If you’re concentrated in one sector like the tech industry, what happens when there’s some kind of political change or other variables that impacts the sector?

• Countries: While some countries may perform better than others at a time, there’s no guarantee that it will continue. Diversification based on countries can also be an effective strategy. 

• Asset classes: Most people are familiar with stocks and bonds. Stocks don’t always outperform bonds, so adding bonds into your mix can help reduce asset class risk through diversification. 

Investing in just one company, one asset class, one sector, or one country creates a very wide dispersion of potential returns. This means you could either have larger-than-average returns if it does well, or you could lose everything or an outcome anywhere in-between. 

But once you start bringing in additional companies, asset classes, sectors, or countries, you increase your diversification and shrink your potential dispersion of results—all while hopefully meeting your investment goals. 

The Bottom Line: A Case for Diversification

Unlike other parts of this series (active vs. passive, tactical vs. strategic, and stocks vs. bonds) where I present both sides pretty neutrally, I am recommending one path over the other here.

I believe that the average investor will benefit from a diversified portfolio because it protects against risk while helping you reach financial goals. 

But if you need even more convincing, let’s look briefly at a study: Do Stocks Outperform Treasury Bills? by Hendrik Bessembinder (2008). 

This study analyzed 90 years of data for over 25,300 companies that issued stocks. He found some interesting results: 

• The stock market was responsible for $35 trillion in wealth creation

• Just five companies (Exxon, Apple, Microsoft, General Electric, and IBM) were responsible for 10% of the total wealth creation

• The 90 top-performing companies (less than 1% of the companies studied) accounted for 50% of the total wealth creation

• The 1092 top-performing companies (about 4% of the companies studied) accounted for the rest of the wealth creation. 

In short, this data shows that just 4% of companies over a 90-year period contributed to the wealth creation of the stock market. 

And, on the other hand, 96% of companies were only able to match the gains of one-month treasury bills; they did not return a rate above and beyond that. 

What are the takeaways here? Depends on how you look at it: 

• If you figure out the 4% of companies that will succeed, you can invest only in those and make the most money (a concentrated strategy). 

• If you invest in the entire stock market, you’ll already own those companies in the 4% that are carrying all the weight. So you get the advantages of their success without having to figure out which ones they are—all while minimizing risks through ownership of other companies (a diversified strategy). 

And since most of us do not have the knowledge, resources, or risk tolerance for the first option, diversification is typically the best approach. 

The truth is that none of us are Warren Buffett or Mark Cuban. And even though they think “diversification is for idiots,” I can assure you that it’s a critical aspect of your investment approach.

But, it’s a big topic! Take a listen to the full episode on diversification vs. concentration if you want to dive deeper. 

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Evan Neufeld is a CERTIFIED FINANCIAL PLANNER® professional in Saskatoon, Saskatchewan and offers both investing and fee-only financial planning services.

*Disclaimer: Any numbers or rates of returns are used for illustration purposes only and should not be taken as fact. Note that the information in this article is current to the time of writing but is not guaranteed as up-to-date past then.

This article and accompanying podcast do not constitute personal financial advice. Evan Neufeld is a CERTIFIED FINANCIAL PLANNER professional in Saskatoon, Saskatchewan, and provides this Canadian personal finance content for educational purposes to the public. You are welcome to contact Evan to receive personalized fee-only financial planning or investment portfolio management.