Diversification
Personally I am not a fan if diversification. I am afraid this is a contrarian view. Most people and institutions will tell you never put all your eggs in the same basket. As if putting the eggs in six different baskets will protect them against a 7.0 Earthquake. It will not. However, that is not the point. The point is diversification is a good strategy and a safe strategy when executed correctly. However, before I get into more detail, let us discuss definition and pros and cons first.
Diversification in investing is a strategy where investors spread their money across a variety of investments, including different asset classes, industries, and geographies, to reduce the risk of losing a significant portion of their portfolio if one investment performs poorly.
Diversification have the following benefits:
- Risk Reduction: Diversification lowers portfolio volatility. Modern Portfolio Theory (MPT) shows that combining assets with low correlation reduces unsystematic risk without sacrificing expected returns.
- Consistency: Diversified portfolios tend to perform more stably across market cycles, avoiding catastrophic losses from concentrated bets.
- Tailored Diversification: Within stocks, diversifying across sectors (e.g., tech, healthcare) or styles (growth vs. value) can capture upside while mitigating sector-specific downturns.
Arguments for Mediocrity:
- Dilution of High Performers: By spreading investments across many assets, you may reduce the impact of top-performing stocks or sectors. For example, holding 50 stocks means a single stock’s 100% gain has less impact on your portfolio than if you held only 5 stocks.
- Market-Like Returns: Broad diversification, such as through index funds, often mimics market performance (e.g., S&P 500). This can feel "mediocre" compared to concentrated bets that outperform during bull markets.
- Over-Diversification: Studies suggest that beyond 20-30 stocks, additional diversification yields diminishing risk reduction. Holding too many assets may lead to average returns with unnecessary complexity.
The chart above is relatively simple to read. It shows two lines, risk and return.
- X-Axis: Number of stocks in portfolio (e.g., 1, 5, 10, 20, 50).
- Y-Axis: Portfolio risk (standard deviation of returns) or return (%).
Data Example:
- 1 stock: High risk (~30-50% std. dev.), variable return (e.g., 0-20%).
- 10 stocks: Moderate risk (~20% std. dev.), return closer to market (~10%).
- 50 stocks: Low risk (~15% std. dev.), return near market (~10%).
The key thing to note from this plot that risk decreases rapidly from 1 to 20 stocks, then flattens. Returns stabilize near market average.
However, the next point is even more critical. Once you have about 20 stocks in a portfolio, increasing it to 50 has no effect.
We can increase the number of data point, and variable ranges, but the outcome will remain the same.
This plot is the main concept that led me to think that:
Diversification guarantees only one thing: mediocrity
Empirical Evidence
- A 1986 study by Meir Statman found that 20-30 stocks provide most diversification benefits in terms of risk reduction.
- The S&P 500 (highly diversified) has historically delivered ~10% annualized returns (1928-2024), competitive with many active strategies.
- Concentrated portfolios (e.g., Warren Buffett’s Berkshire Hathaway) can outperform but carry higher volatility. For instance, Berkshire’s annualized return (1965-2024) is ~20%, but with significant drawdowns (e.g., -44% in 1998-2000).
These are all facts but still my hypothesis is not easy to test.
Seeking Alpha!
We arrived at Alpha. The elusive alpha, everyone is after it, but few can get it. It is also said that alpha is luck, and no one (or very few people) can consistently do it! So what is it?
Alpha in financial markets represents the excess return of an investment or portfolio relative to a benchmark, typically a market index like the S&P 500, adjusted for risk. It measures the value an investor or portfolio manager adds through active management, such as stock selection or market timing, beyond what would be expected from passive exposure to the market.
The chart above is just like the previous two charts, but with another green line added. This is the return of a portfolio that generated a higher return because of a positive alpha.
- Yellow Line (Risk): Shows risk (standard deviation) decreasing from 40% (1 stock) to 15% (50 stocks) as diversification reduces unsystematic risk.
- Red Line (Actual Return): Shows the portfolio’s hypothetical return, starting at 12% (1 stock) and converging to 10% (50 stocks), reflecting market-like returns with high diversification.
- Green Line (Expected Return): Calculated using CAPM, it starts at 14% (beta = 1.5 for 1 stock) and converges to 10% (beta = 1.0 for 50 stocks). This represents the return expected given the portfolio’s risk exposure.
- Alpha: The vertical gap between the red and green lines.
Notice, that 20 stocks, it is nearly impossible to generate alpha. So by definitely, if you seek alpha, you must run a concentrated non-diversified portfolio.
Real Data :)
What if I had a 5 stock portfolio over the last 10 years? I did. All these names are well known.
NVDA =50%, AAPL = 20%, MSFT = 20%, NFLX = 5%, AVGO =5%
What if I run the same plot with this data?
No Shit!
Who said that market return is 10% annualized?
- Yellow Line (Risk): Starts at 142.05% (NVDA’s risk for 1 stock), drops to 84.49% for the five-stock portfolio, and converges to 17.07% (SPY’s risk) at 500 stocks, showing diversification’s risk reduction.
- Red Line (Actual Return): Starts at 111.64% (NVDA’s return), hits 78.62% for the five-stock portfolio, and converges to 14.00% (SPY’s return), reflecting the portfolio’s outperformance.
- Green Line (Expected Return): Starts at 21.20% (beta = 1.6), hits 18.32% for the five-stock portfolio (beta = 1.36), and converges to 14.00% (beta = 1.0), based on CAPM.
- Alpha: The gap between red and green lines.
At 5 stocks:
Actual Return: 78.62%
Expected Return: 18.32%
Alpha: 60.30% (significant outperformance, driven by NVDA’s high returns)
The concentrated portfolio (5 stocks) generates substantial alpha (60.30%) but with high risk (84.49%). As diversification increases, alpha approaches 0, and returns align with the market, confirming my earlier concern about diversification potentially leading to “mediocrity” (market-like returns).
Basically, you need one winner, that's all. Often the winner is well known, and it is no secret and in plain sight.
PS. I used numpy and matplotlib to generate these plots. Trying to have fun with python.
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Isn't the old advice "If you want to get rich, pick no more than 1-3 stocks. If you want to protect what you have or don't know what you're doing, diversify". Or something like that.
Yes, that was an old school advice. I can say, I have seen that with my life. Almost 90% of my net worth is generated by two stocks. AAPL and NVDA. Different decades, but just two.
My base strategy is diversification and DCA, slow and steady is the plan.
Diversification by ETF selection, some individual stock for the fun, higher risk. Small percentage in crypto also high risk imho.
Diversification within crypto not going so well... you know which project to blame here 🤣
Diversification is not bad, and you can be wealthy doing it, but it takes a long time.
When I was in school in the late nineties, I bought AAPL. I held and added to it throughout 2000s. Just before the financial crisis of 2007 I was graduating from university and going to start my job in Houston. I sold most my AAPL stock and it was enough to buy my first house outright. Before I started my first real job. The timing turned out to be most excellent because it was the right time to get out of the market.
After that I continued investing in AAPL from the depth of the market crash, and started investing in NVDA. A close friend of mine got a job there and mentioned how nicely run company that was at the time.
I invested heavily in NVDA. Rest is reality :)
Impressive good analysis or luck?
There are also many ppl that bought Intel at the wrong time (2000) if they did not DCA it took a long time until hit par again 2015 or so?
But for me i started way to late here in the NL they are not that investing minded and no education at school at all.. Whish i started earlier learning more about money..
In the V.S. investing more common or also not?
So strange right, you learn everything, except how to spend money the right way, but I guess when they teach it the right way, the 'system' doesn't work anymore (most people just work and be slaves to the tax paying system that is)
By the way, I didn't know you're from NL as well 🙂
Now you know 🤣.
I forgot to answer this.
I say perhaps it is more common compared to India, where I went to school as a kid.
But it is not perfect here either.
I learned about finance, because I got into currency trading when I was 16 year old :)
Luck :)
Even I am not a fan of diversification because of my limited ability to manage many things consistently for a very long time - rather focusing on few things and getting them correct feels better and safe - most importantly less stress.
I agree. At one time I had 50+ crypto tokens that I have personally invested, not airdropped. Most of them are gone :) clearly diversification didn't work in the summer of 2020-21 :)
Saving for my kids, I try to diversify because it's long term and I want to lower the risk so they will have a nice start in grown up life, besides stocks, bitcoin seems the obvious thing if you believe in crypto (I think everyone on hive does lol)
For myself, investing wise it's very heavy in to bitcoin, nothing I can't afford to lose but I think it's better than put it in the governments retirement plan.
This also goes for web 3 gaming, people told me not to put all my eggs in one basket (the basket being Splinterlands) so when I started in web 3, I listened and then some other games I played and put money in died, so I went on with SPL only because it was what my guts told me was right. Gaming is not investing at all, it's fun money but still it can give a nice return on top of the fun.
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It appears crypto isn't even that safe anymore from diversification. With it being so closely tied to the stock markets with ETFs now, even small moves in one sector can have an impact in others.
Crypto is highly correlated with broader market these days.
It sure is!
It depends on personal factors as well... In 2022, I got smacked around a lot (I was new and did a lot of bad decisions regarding stocks). I had anticipated that, and only used a little capital until I felt more confident. Starting 2023, my returns were really good - and I'm able to deploy more capital.
That means: I'm good with high volatility. I do have a lot of diversity, but some of those stocks are leftovers from 2021 and early 2022, I just don't have a need to sell them. But on what I'm buying, I'm concentrating a lot more, so my portfolio is getting more and more top-heavy. That's because I feel more confident about my analytic skills now.
It's still too many. Very interesting that there's no change between 20 and 50 anymore. I'll start reducing whenever I see opportunity I guess.
Thank you for the detailed argument!
Ya i used to have like 100 plus but it was just a shit show of worrying about all these stocks and the index funds you get good ones but a whole bunch of shit to that gets propped up by every 401k just buying the index weekly lol. I would agree with the less diversified approach for a better chance at getting way outsized returns and you can do a few things to protect gains if you get some as well with options to but I tend to use puts to enter into positions by selling them its like they pay you to buy a stock at the price you want. If it goes up you keep the cash and wait for the next opportunity or do some of both if you want to get a core position and then sell some puts to add if it does what you want it to do. Same with calls if volatility is high and you think its going sideways calls can be a good way to generate some extra income but u risk being called away and losing some upside. Lots of fun ways to play the market. In crypto I tend to like say buying ETH then shorting it on a futures dex or multiple ones that do airdrops so i get the funding rates which tend to be high plus there token which usually produces decent revenue when staked and if you find one that you have analyzed a lot and understand who the ppl are and are confident then its less risky but still i don't go crazy with those just experiment with a lot of them getting like 40% delta neutral and collecting tokens and then staking them once the initial reward periods over i move to the next same with airdrop farming since i already hold x pairs might as well move them to a chain where ill get a few gs in free tokens like ZK or ZRO were some good ones over the past years i got for doing nothing but moving my LP from one chain to the other.
Sounds good! Good luck! I'll stick to stocks for now, I don't really understand that token stuff :-D
ya if you don't understand a investment best not to mess with it unless you want to learn about it and then understand it there are 1000 ways to skin a cat lol
I have said this somewhere here. I am wealthy and financially free. This is a fact that 90% of my net worth is generated by holding just two stock over decades, first it was AAPL and then NVDA.
Well those definitely were excellent choices :-D Congratulations! Maybe I'll have one of those one day, but I'm not that good yet to be confident enough to hold only one. I'll let you know when it comes to it...
High risk, high return. Most people can't predict top performing stocks of the future, let alone crypto :) If I were to pick 5 stocks now, not sure what I would be picking. MSFT, Google, Amazon, Apple and BLK?
Nothing wrong with those five.
You think those are conservative picks? I see you like NVDA, that seems a lot more risky after the run up it had... I am basically picking the new Coca Colas with the exception of the Black Rock which is a bet on Crypto :)
if you measure the risk by their standard deviation or beta, then obviously NVDA is risky. I just looked up its beta
Its beta is 2. That translates to it is about 2X more volatile that S&P500. So 2X more risky than SPX. However, for that higher risk profile its annualized return is 110% over 10 year rolling. I am totally comfortable in taking 2X risk compared to the market for a 10X return compared to the market.
Do you see my logic?
Yes, I see that 10x return for 2x the risk vs S&P500, does sound pretty good...
What's the next winner?
NVDA
I have to say I'm a little doubtful that $NVDA has another 100% rise over the next 10 years... but I guess we'll see.
Well, the previous 100% was yearly gain, not the total gain in 10 years. It was 110% each year for 10 years :)
Whoa! It's doubled every year for 10 years?!? That's incredible.
Be very interesting to see what happens over the next ten.
I put most if not all my eggs in Hive and HBD. I think that this is enough diversification for me. I still need to invest way more money before it will bear any fruits. But If I could have 10-20k HBD and 50k HP at some point that would start making a real difference.
I can't tell you if that is a good idea or bad, I have my own biases.
Quite a complex and easy to get wrong topic here for me.
Since everyone is betting on the well known stocks like MSFT and Google, I guess I might just follow the masses...
I do know that Tesla is a very shaky basket now...
Yes, your guess as as good as mine.
Good day.
Just sending my greetings in appreciation of your contributions to the progress of the this community
Agreedd!!
I experiencing myself, diversing my asset will make my return really small.
However, yeah the risk is lower, not exactly the risk. But, i think it like less feeling scare if something happen with the platform. Since on Crypto especially many platform going big and suddenly bankrupt. And if that happened on one of my place investing, it would be disaster if i am going all in.
But no hard feeling i am team diversification
!ALIVE
There are two different types of risks
Systemic and nonsystemic.
There is no protection against systemic risk. If a meteorite hits planet earth diversification won’t protect you. That’s systemic. However, we don’t have to go that far fetched. A recession is also systemic, diversification won’t protect you there. It used to, but not anymore in the highly connected world.
On the other hand diversification might protect you somewhat against say collapse of Luna or Thorchain. As most of crypto is scam anyways. That's nonsystemic.
hmmm...thats new lesson for me.
I guess i just can manage the nonsystemic risk here.