Surely by now you will have heard the term ‘diversification’ being used when talking about investing. However, a less well known buzz-word, ‘diworsification’ is important to know as well. Personally, I first came across this term in one of Peter Lynch’s books which is ironic considering some have said that he never met a stock he didn’t like – which is in reference to his Magellan fund holding more than 1,000 holdings at one time.
(*As Frugal Trader from the Million Dollar Journey points out in the comments section, Lynch originally used the term ‘diworsification’ to describe a company that expanded into businesses beyond their core competencies.)
Diworsification refers to the fact that you can diversify too much. For example, if you own 1 company’s stock you could potentially hit it big, but you could also lose it all. If on the other hand, you owned 100 companies (in equal weight) and one company went bust or doubled over-night, the net impact to your portfolio is only +/- 1%. Further, if you owned 1,000 stocks and one company either tanked or doubled, the effect on your portfolio is only +/- 0.1%.
The premise is that as a stock picker, naturally you would select the stock with the best prospects first, and then the second best, the third best, etc. But at what point do you get to the ‘n’th stock that has a lower growth prospect than the market as a whole? Or put another way, at what point are you just adding holdings to your portfolio for the sake of adding holdings, without really understanding what you are buying? If you hold too many securities then the winners won’t have a significant impact on your portfolio’s performance (nor would the losers). You might as well hold everything without giving it any further thought (i.e. perhaps using an ETF).
Many times I have seen an investor with 5 different mutual funds from 5 different fund companies and all of them invest in Canadian equities – there is significant overlap in the holdings and yet the investor might think they have diversified since they have 5 mutual funds instead of 1. More prudent would be to have one Canadian equity fund and then some funds that invest internationally as well, and perhaps a fixed income fund to temper volatility.
If you invest using ETFs which may provide broad market coverage and have 100s of individual stock holdings, you don’t need to worry about diworsification within the ETF – the mandate normally is to fully capture the returns of the index less a very small fee – which they do. But if you are using actively managed money (funds or individual stock picking) and your goal is to beat the market, then you might be interested in gauging any possible diworsification.
Warren Buffett once said that an investor should be given a punch-card with 20 spots on it. Any buy or sell transaction would cost you one of the twenty spots on your card. Once you got to 20 – that’s it, no more transactions. (This is not per year, but rather for your entire life.) If you did that, you would probably take more time to understand your investments, and be better off because of it. You certainly wouldn’t be accused of diworsification either. :)
Preet, I always thought that Peter Lynch’s “diworsification” meant that when a company expands beyond their area of specialty. For example, if Exxon Mobile decided to expand into the banking sector. However, I can also see how it would apply to the individual investor.
@FT – you are quite right – Lynch did talk about companies expanding beyond their core competencies and called this diworsification. I think that since then the concept of diworsification has become accepted as the process of adding to one’s portfolio to the detriment of the risk/return trade-off (which can apply to a company’s portfolio of assets/business lines or an individual investor’s investment portfolio). I’ll add a note to the post – thanks for the great comment!
Good reminder, specially now when there’s some good companies at very reasonable valuations. Too easy to jump on the proverbial horse and ride off in all directions. Thanks, Preet.
Great article. I think many people don’t understand the true meaning behind diversification. If one holds a portfolio of pure energy companies, or example, some might consider that they are ‘diversifying’ by investing in different energy companies. When in reality, these companies might be positively correlated. I think a good measurement of how strong one’s portfolio is diversified is by using measurements of correlation. True diversification to me means negative correlation (diff industries, diff size, diff countries)
The classic Canadian example of diworsification is Nortel in the dot come bubble. A lot of investors (myself included) unknowingly diworsified instead of diversified even when owning a broad group of mutual funds, only to find out that because of loose investment mandates (and mutual fund mangers trying to chase performance) they all owned a chunk of Nortel.