Not All Diversification Is Diworsification

Diversification is a grey area of the investment world, with many investor believing that diversification will determent a portfolio's performance. However, this often stems from a misinterpretation of the words of two of the most famous investors of all time, Warren Buffett and Peter Lynch.

 Diworsification is a term coined by Peter Lynch to describe the process of adding investments to a portfolio at the detriment of the risk-return trade-off. Additionally, Warren Buffett has famously said that diversification is "𝙥𝙧𝙤𝙩𝙚𝙘𝙩𝙞𝙤𝙣 𝙖𝙜𝙖𝙞𝙣𝙨𝙩 𝙞𝙜𝙣𝙤𝙧𝙖𝙣𝙘𝙚", referencing the fact that most investors should forget purchasing individual stocks unless they are willing to put in the work.

Surely we should only concentrate on a few stocks then right? Well, not really.

Starting with Warren Buffett's comments, when he speaks of ignorance he is not referring to intelligence. Instead, he is informing us that without putting in the work to research our investments we are ignorant to the risks involved. This is further evidenced by Warren's full quote that diversification is "protection against ignorance. But that's OK.". It's ok to be ignorant, as long as investors are sensible about their risk-reward expectations.

Moving to Peter Lynch. Whilst many believe that he is adamantly against diversification (calling it diworsification), this is again a common misunderstanding. What Lynch is trying to tell us is that we should not diversify for the sake of diversifying. This is not to say that if a good opportunity presents itself it should be ignored to avoid overdiversification, instead we should ensure each new investment will benefit the portfolios return without worsening the risk. Again, the proof is in the pudding when we look back at Lynch's Magellan fund, which held over 1,400 stocks by the time Peter Lynch retired.

Knowing this, rather than being afraid of diversification, we should embrace it as a tool. There is no need to have a set number of investments in mind (10, 20, 30 stocks, etc.), instead we should invest in the opportunities that make sense, so long as we can give each and every investment the attention it needs.

Further information can be found here: https://www.investopedia.com/terms/d/diworsification.asp#:~:text=What%20Is%20Diworsification%3F,the%20benefit%20of%20higher%20returns.