Mohnish Pabrai: Quality Over Quantity: A Counterintuitive Guide to Diversification

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In this interview with The Value Perspective, Mohnish Pabrai explains why investors shouldn’t blindly chase diversification. They should focus on understanding a few companies well instead of spreading themselves thin across many that they don’t fully understand. True risk reduction comes from deep knowledge within your “circle of competence”.

Key points from the interview include:

  • Adding more stocks to your portfolio doesn’t always equal more diversification or reduced risk. The benefits quickly diminish after a certain point.
  • Four or five stocks in different industries is already considered a well-diversified portfolio.
  • Increasing from 10 to 20+ stocks can be counterproductive: the low diversification gains don’t outweigh the risks of stretching your knowledge too thin.
  • Staying within your circle of competence, where you deeply understand the businesses, minimizes risk. Diversifying beyond that can introduce knowledge gaps and risk.
  • The optimal number of stocks is subjective, but once you exceed a few names, the risk reduction plateaus significantly.

Here’s an excerpt from the interview:

Pabrai: If you study the subject the amount of benefit you get in terms of diversification and reduction of risk starts to go down really quickly as you add more positions.

So obviously if you had a single stock portfolio that’s at the extreme end of the risk curve.

But once you’re at about four or five positions in different Industries you’re already quite diversified. Once you take that number up to 10 that’s a significant well diversified portfolio.

But when you take it from 10 to 20, or 30, or 50 now you’re hurting yourself because the minimum benefits you would get from diversification would be more than offset with the lack of knowledge of those businesses.

So when we stay very narrow we are basically going to be at the epicenter of our circle of competence. We understand those businesses really well.

As you start layering on more things and more companies there’s going to be a variance in terms of how well you know the businesses, and not knowing the businesses well enough even in a highly diversified portfolio is risky.

So from my point of view once we get past a few names the risk profile really does go down.

You can listen to the entire discussion here:

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