Case against (over) diversification
Not VC Series >> Building a Conscious Fund
I have seen people throw this word as if investing in 40-50 companies reduces their risk of bad decision-making and selection processes. That’s far away from the truth.
I believe, as Charlie Munger says pretty explicitly, widespread diversification leads to mediocre returns at best. Especially in venture, it is hard to find quality investments, so why not concentrate on a few? It seems to be a legit good idea practiced by the champion of quality investing, Charlie Munger, but sadly, most people from the investment world don't think this way.
Diversification, or holding too many different assets and investments, can lead to several issues:
Conviction issues » Excessive diversification leads to a lack of conviction. With small positions spread thinly across many assets, you likely won't have firm conviction behind any one investment. This spray-and-pray approach means you are not putting enough weight behind your best ideas. It is nothing but a gambling game, then.
Where is the focus? » Remember, VCs point out this to founders all the time. Managing a complex portfolio with dozens of holdings takes time away from developing expertise in your best investment opportunities. There are only so many hours daily, and over-diversification spreads an investor too thin.
Warren Buffett: 12 Mistakes Every Investor Makes by The Swedish Investor Hence, many call Charlie/Warren as focused investors. Lol, isn’t that the focus of all the great investors?
“In his view, a portfolio of three is enough diversification.”
Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger
An expensive affair » It increases costs and taxes. With each additional holding comes additional transaction fees, management expenses, and tax drag. Costs can eat away at returns in an over-diversified portfolio.
Mediocrity » When the capital is spread thinly across too many companies, as an investor, you cannot allocate enough to their highest potential investments. This prevents them from fully capturing the outsized returns that often come from a select few exceptional winners. Concentrated portfolios allow properly capitalizing on the highest conviction opportunities.
I wrote a draft manifesto for budding venture capitalists and venture studio managers » Be a contrarian, focused, concentrate, show high conviction, and provide active support (don’t shy away from problems and be passive-aggressive). I made this a while ago with a great wise young friend, Christian Van Schoote.
Contrarian Investor: we don’t follow trends.
Focused Investor: we only invest in industries and business models we understand.
Concentrated portfolio: we take a significant stake and invest in a few companies.
High Conviction Capital: we deploy patient capital and prefer to be the first institutional investor.
Active support: we don’t shy away from problems we can solve - we prefer to get actively involved.
If you want to be passive and diversify; better put money in an ETF like VEGN by Beyond Investing or invest in index funds like the S&P 500. But if you do that, please don’t call yourself an investor with any competence :).
I will end with a quote by Charlie Munger »
"An idiot could diversify their portfolio."
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Sign-off for humanity,
Sagar
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Stay humble, stay curious 🌟🌟🌟!
Note: These are my personal opinion.
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