In this interview with 3 Takeaways, Howard Marks discusses the different types of diversification in investing. Ideally, these investments should react differently to various situations. For example, having many stocks in companies that all rely on China is not true diversification. True diversification is a trade-off between risk and reward. Here’s an excerpt from the interview:
The obvious one is diversification. And diversification is not a magic elixir, it merely says that if you don’t have any big positions you can’t have any big losses. Spread it out.
It is possible for something systemwide to happen which affects all your investments even if you have them spread out in many places, but usually if something goes wrong with company A that doesn’t mean it goes wrong at Company B. So you have diversification.
Now when you diversify you have to remember it’s not having a number of things, it’s having things that respond differently to a given situation.
So if you have a 100 stocks but they all get their supplies from China then you have one exposure. It’s important to bear that in mind.
But I always say we diversify to protect against what we don’t know. We concentrate to take advantage of what we do know.
If you are a great stock picker and you have one favorite maybe you should put all your money in it. If you invest instead in 10 things or 50 things or a 100 things you’re diluting whatever appropriate judgment you made about that one good one.
So diversifying is a matter of sub-optimizing. You trade away downside risk and you give up some upside potential at the same time.
That’s the cheapest form of risk control available, but it also has a negative impact on return, and you can’t ignore that.
You can listen to the entire interview here:
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