Mutual Funds Awareness 102: The opposite of Diversification is Focus
Diversification is a topic frequently discussed, especially in the world of mutual funds. Rightly so, because people who invest in mutual funds may be newcomers and want some safety for the funds they commit.
Diversification is the process of buying a basket of stocks/assets in such a way that the losses are minimized when the market goes down. Diversification is protection on the downside, but the downside of diversification is that it won’t perform on the upside. Confusing? Let me clear the air around it today.
There are 2 categories of investors.
- People who know what stocks to buy.
- Everyone else.
Probably less than 1% of total investors are of the 1st category. They either end up super rich or bankrupt. If the stocks perform well, they end up creating huge wealth. If they pick wrong, they end up losing money.
The 2nd category of investors forms the middle ground. They do not get super wealthy or go broke as they fit perfectly within these extremes. For these people, mutual funds are the best vehicle ever invented. You will never go broke investing in a mutual fund (any category, scheme or fund manager considered). The worst case: your investment end up generating returns lower than the benchmark.
Similarly, you cannot create super wealth using mutual funds. Yes, you can create a lot of wealth, but not super wealth — the reason is diversification. When you split your money among 100 or 500 stocks, the weightage may be very meagre to make an impact. For example, if a stock with 0.5% weightage goes up 20 times, your portfolio will only go up by 9.5%. See, that is the disadvantage of diversification.
Diversification is the art of buying multiple assets at the same time so that even if one or two assets underperform, the overall portfolio is not impacted, as there could be other assets that outperform. A fund manager carefully selects multiple assets/stocks that are negatively correlated, meaning if one of the assets goes down, the other one goes up. For example, gold and stocks. If there are uncertainties, stocks may underperform, but at the same time, a safe-haven like gold will rise.
Diversification was invented to attract non-financial people to the stock market. People like doctors, engineers, lawyers, and corporate employees can be lured if the returns are mesmerizing, but they will only stay if there are some wealth protection measures. Without protection, the stock market would end up like a casino.
The opposite of diversification is focus. You invest your capital in a handful of assets and then hold them for dear life. Super wealthy people have a focused portfolio, with 70 to 90% of wealth coming from 3 or 5 companies.
Mohnish Pabrai’s Portfolio — source.
235 million USD ~ 2000 crores worth of assets are in just 4 assets.
Charlie Munger’s Portfolio — source.
97% of 215 M USD ~ 1800 crores of assets are in just 3 assets.
Clifford Sosin’s Portfolio — source
99% of 1539 M USD ~ 13229 crores of assets are in just 3 assets.
Warren Buffett’s Portfolio — source
80% of $258B+ USD ~ 18 lakh crores of assets are in just 7 stocks.
The inference is clear: focus generates super wealth. Diversification just protects your capital.
In the initial years, you could start with highly diversified mutual funds, but once you have hit a stable portfolio, you should start narrowing your focus. If you are still worried on how to get that done, there is a category of mutual funds called “Focused Funds”, you should try that.
Focused funds invest in not more than 30 companies, across market caps (large, mid or small). It is an actively managed fund, wherein the fund manager decides what weightage should go to stockA, stockB, or stockN. There is an element of diversification in this fund as well, but as the name suggests, the “focus” still stays.
If you do not have focused mutual funds in your portfolio, you should get them audited by a qualified financial advisor ASAP. For my clients, I always add focused funds to their portfolio in their 2nd or 3rd year of investing, after they have mastered the zig-zag nature of mutual fund returns in general.
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