Diversification or Di-WORSE-ification

By Joe Ferreira

There is an old proverb that people apply to investing: “Don’t put all your eggs in one basket.” On the surface, this appears to be very sound advice: spread your eggs into multiple baskets to reduce the risk of all your eggs breaking. However, the late 19th-century steel tycoon Andrew Carnegie provides a contrary take: “Put all your eggs in one basket, and then watch that basket.” Warren Buffett (aka The Oracle of Omaha) and other prominent investors share a similar “one basket” investment philosophy.

Who to believe? If you are of the basket spreading persuasion, how many baskets should you pick? If you are a proponent of the one basket theory, how do you pick the basket, and how do you know if you have the wrong one? What the heck is a “basket”?
The answer – like all great finance questions – is “it depends”. It depends on what you are trying to do and how dependent you are on being right. The basket analogy in this context refers to what the investment world calls diversification.

Diversification in its simplest form means having a mixture of different things, or in this analogy, spreading your eggs into multiple baskets. The “eggs” are your financial assets, and the “baskets” are asset classes (typically stocks, bonds, cash, real estate, and commodities). The idea behind diversifying (i.e. buying two or more asset classes) is to increase the odds of picking the best performers and eliminate the chance of owning only the worst performer.

But wait! Doesn’t that mean I will increase my chances of picking poor or mediocre performers? This is the heart of the diversification question.

Asset classes tend to perform differently to each other over short periods of time (over long periods of time they appreciate). Precious metals might do well when the economy is hurting and stocks are doing poorly. Real estate might crash while cash holds its value (I know, I know…that’ll never happen!).

By holding different types of investments (asset classes), you accept ownership in both high performers and some that are just mediocre. By investing in only one asset class, you are taking a risk that your thesis is incorrect (your chosen basket is a poor performer). If you’re right, you might achieve tremendous returns (a la Warren Buffett). However, if you’re wrong, you might “lose your shirt”.
The ultimate goal of diversification is to minimize risk. Said another way, the goal is to give you the highest odds of achieving a satisfactory return.

So what makes sense for you?

If you need high returns and can afford to lose in the short-run (perhaps you have high-income potential, time horizon, and risk tolerance), maybe you should follow the Buffett method and go shopping for the right basket. If that’s not you (perhaps you’ve already saved a tidy sum and would like to live off it one day), I advise you to find a few baskets and spread the eggs around.