Mark Twain famously said: “Put all your eggs in the one basket and — WATCH THAT BASKET.” (Pudd’nhead Wilson, Chap. 15) While I’m not sure about Mr. Twain’s expertise in financial affairs, the quote is sometimes attribute to Andrew Carnegie, who said much the same thing.
This flies in the face of the commonly accepted doctrine of diversification. Diversification is held to be so important, that many mutual funds hold the shares of hundreds of companies. This is sometimes called “closet-indexing,” because the performance of a fund, owning hundreds of companies, (before fees) and an index, owning hundreds of companies, must necessarily be similar. This is a large part of the argument for ETFs.
Now think of how Andrew Carnegie built his wealth. Or the Rothschild family. Bill Gates and Steve Jobs both made their money by building up a single business. Paul Demarais, in Canada, built his wealth through his company. There are few successful stories of people becoming wealthy by investing in a large number of unrelated businesses. Even Warren Buffet focuses on a small number of companies that he understands very well, in addition to his insurance operations.
To understand why this is, let’s assume a money manager can pick a company whose share price will increase rapidly. A manager with a fund that owns 150 companies would give it a relative overweight at 1.5%. If it doubles over the year, it contributes 1.5% of annual performance to the fund. A manager with a fund that owns 30 companies would give it a relative overweight of 6%. If it doubles, it contributes 6% of annual performance. It has been suggested that the Kelly bet size algorithm would optimise this type of investment decision, although the assumptions are not applicable to stock market investing.
The lesson, as has been pointed out by Charlie Munger, is to allocate capital in direct relation to the attractiveness of opportunities. This is the way to maximise growth over time. Conversely, there probably exist people who put much of their capital into a single venture and were wiped out. We’ll never know, because these stories rarely make it into the media.
For people who don’t understand the companies they own, diversification compensates for mistakes by not allowing any one mistake to affect more than a very small portion of the portfolio. For people who understand very well the companies they own, they will still diversify as a way to avoid ruin. If you own one business, you could be wiped out. If you own five unrelated companies, the chances of all going bankrupt at once are much smaller. Even if you lose money, you’ll survive to play another day.
The optimal way to grow wealth is to focus your investments in a small number of the most attractive opportunities. As long as you guard against ruin by not exposing your capital to the risk of total loss, increased diversification will only bring your results closer to average.