Diversification vs. Focused Investment

When investing in shares, a question often asked is whether it is best to spread investment across the shares of several companies or concentrate on just one or two.

This question could extend to business sectors as well as individual companies, of course, for diversification is not complete unless investment is spread across different sectors and then across different companies within those sectors.

The case for diversification

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Much investment theory hangs on minimising inherent investment risk. Not all assets move in the same direction, or at the same pace, at the same time. When property is thriving, bonds may be underperforming.

Asset diversification removes the risk of being invested in the wrong asset at the wrong time, and negates the need for premium market timing. This theory holds true when investing in shares.

Investing in a single company carries the risk that a catastrophic event befalls that company. For example, consider the investor who has invested in company A who specialise in making widgets because he believes that the widget market is about to explode. He has undertaken research and feels that company A is undervalued when measured against its peers.

He turns out to be right: the widget market moves forward at a lightening pace. But, even though his view of the sector was spot on, company A’s biggest customer went bankrupt because of money owed to it by a third party company. Consequently, the share price of Company A plummets and the investor loses money even though he had the right view of the market.

If the investor had bought shares in all the widget manufacturers, this company specific risk would have been eliminated. Even though he would have lost money on his investment in Company A, his investments in all the other widget manufacturers would have more than made up for this loss.

There is also sectorial risk to be considered.

For example, an investor may believe that distribution companies will do well over the course of the next twelve months. Consumer confidence is high and goods will need to be moved from manufacturer to wholesaler, and from retailer to customer. So he buys shares in a dozen distribution companies. For a while the distribution sector does well, but then political problems raise their head in the Middle East and the oil price rises – a lot.

Suddenly distribution companies are faced with increasing fuel costs, and margins are hit. Their profits tumble and share prices follow.

If the investor had widened hi focus, he would have had some profits from holdings in the shares of oil companies to offset against his losses on his shareholding in the distribution sector.

Diversification is about spreading investment to minimise risk.

The case for focussed investment

492px-Warren_Buffett_KU_VisitContrasting with a diversified investment approach is the focussed investor. They will make a play on a single stock or a very narrow portfolio of stocks. Comprehensive research will have been conducted, and every possible scenario allowed for.

The investor will know that Company A, the widget manufacturer, relies on one customer for the majority of its profits and will have considered the financial wellbeing of that customer when making his investment decision. Before making the investment he will be 100% certain that he is backing the company that will be gaining most out of the growing widget market.

This is the style of investing adopted by legendary investor Warren Buffett (right). He believes that conviction to allocate a major portion of available funds to a single company – which the investor considers undervalued and mispriced by the market – is the way to make real investment profit.

For an investor who is an expert in a particular business sector, the argument is that the investment risk of focus is lessened by at least the amount that a more generalist and diversified investment benefits from.

The focussed investor is also likely to look for stocks that they believe are unjustly trading at a deep discount to fair value. Warren Buffett believes that buying a long list of stocks not only increases the amount of time needed for research but also increases the probability of buying into a sector or stock that the investor just doesn’t fully understand.

In summary

For the majority of investors, it is probable that a diversified approach will produce better rewards than a focussed investment strategy. However, for those with a certain experience or expertise within a business sector, then a focussed approach might be considered to boost investment returns, though there is always the possibility of the unforeseen event wiping out any profit or, worse still, writing in a large loss.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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