Pros & Cons of Portfolio Diversification | Islamic Finance Guru

In this article, Ibrahim Khan pointed out that most people forget to think much about diversification when it comes to their portfolio and, as a result, they run the risk of over-exposure to a particular element of their portfolio. This could lead to a disaster if that particular part of the portfolio performs badly.

Of course, this is very sensible thinking, and forms part of not only mainstream investment thinking, but also fits in logically with people’s mindsets. ‘Don’t put all your eggs in one basket’, as they say. However, whilst I agree in principle with the concept of diversification, I will be arguing a long-held belief of mine in this article – that diversification is not all it’s cracked up to be.

At this point, you’re probably doing what most people do (including co-founder Ibrahim) when I tell them this – give me a look worse than when you’ve just bitten into a well-hidden elaichi in your biryani. But hear me out.

Weakness

As I said, I agree in theory with the concept of diversification. It’s sensible, logical, and seems like the best way to protect capital. But whilst protecting capital is important, I am of the opinion that yielding fantastic returns is even more important for most of our readership – which is the mid 20s-mid 30s range. This category of people, like me, are usually marrying, starting families, and generally in the ‘building’ phase of their life. If protecting capital is the most important thing for you, my personal view is holding cash is probably best.

So let’s say you are an investor, or potential investor, with £20,000 ready to go and build you some wealth. There’s a few options you have here, but broadly speaking, and purely in relation to shares, you could either:
1. Spread the £20,000 across anything from 7-10 shares, thus diversifying risk; or
2. Spread the £20,000 across 2-3 shares, thus concentrating risk.

So the two broad options are to diversify relatively widely (option 1), or not to diversify very much (option 2).
Whilst option 1 might logically seem the best idea, what I have found in reality is that option 2 works best for me. I’ve thought long and hard about why this might be, and of course it all could just be entirely personal. However, it’s worth relaying some of those thoughts here to encourage discussion.

If I know I’m putting relatively serious money into a particular share, my research is much better compared to if I’m putting smaller amounts of money. The definition of ‘serious’ money will depend on the individual – for some, that might be anything from £1,000 upwards; for others, it might be £15,000 upwards. The actual figure is not important point here – the crucial point I’m trying to make is that if I deem myself to be putting in an amount of money which is serious, I make better decisions. I wouldn’t necessarily say it’s a conscious thing, because any amount of money is important, but I’m naturally much harsher on my criteria when putting in a serious amount.

Compare that with option 1 – spreading the money in small parts over lots of shares. Whilst you might try to do the best possible research and find a good number of shares you really like and believe in, the reality is you probably will not find 7-10 shares that you really really like. Consequently, you end up putting money into some shares which wouldn’t be your first, second, or even third choice, even though you do like them enough to invest some money.

Forgive the facile example, but it’s a bit like going to a restaurant and ordering one of those tasting platters as opposed to a particular dish or two. I only order those platters when I’m at a restaurant I don’t know and I want to sample a wide variety of things rather than risk one or two dishes. But when I’m in a place I know, I can confidently opt for one or two dishes that I know will be fantastic. When I’m investing my own money, I don’t want to put it in a platter; I want in a smaller number of stocks that I know I like, and in which I have serious confidence to give me serious returns.

In short, I think diversification can actually lead to weakness by forcing you to choose a wider number of shares. Whilst in theory diversification decreases risk, there is an argument that by forcing yourself to cast your net wide, you are inadvertently increasing risk. Even if there are 7-10 shares that you really like (going back to option 1 above), the chances are that there will be 2-3 of those that you really really like. Thus, I see concentration of a portfolio as a sign of potential strength, and crucially, an increase in risk:reward ratio.

Risk:reward ratio

Risk:reward ratio deserves some further discussion.

For those unfamiliar with the concept, it is essentially putting numbers on how much risk compared to how much reward you think something has. So with a share for example, if you thought there was a possibility of the share price going down by 20%, but you believed it could also do 100% on the upside, your risk:reward ratio is 1:5.
I personally look for risk:reward ratio of 1:3 or more. That might be considered quite high in some quarters, but again, hear me out.

My theory, as I mentioned earlier, is that if all I want to do is protect capital, I would much rather just keep money in the bank. It’s liquid, I won’t lose anything (except maybe by inflation), and there’s virtually zero risk (save for a total collapse by the bank and the money being unrecoverable, which is extremely unlikely).

But I want more than that from my investments – I want to yield fantastic returns. As such, if I don’t see anything like at least a 1:3 risk:reward ratio, I question if it is worth associating the risk with the money I would be putting in.

Youth

I must admit that my age plays a big part in my investing style. It’s unashamedly high risk, but I am investing in order to make proper money. As a result, I invest only what I could afford to lose if disaster did strike (but of course I try to mitigate against that), but put enough in such that if I realised serious gains, it would be life-changing.

It’s a high risk, high reward strategy that seems to be working well so far. But I’m very aware of the fact that this sort of approach can only really work whilst I’m relatively young with a relatively small pot. As such, I would imagine that as my portfolio hopefully becomes larger as I get older, my investment style would naturally evolve as a result of that. What exactly it would evolve to, I’m not really sure at this point. However, it is important to recognise that this concentration of my portfolio is, I think, a key factor in potentially realising serious gains.

Risk:reward in action

Let’s go back to our earlier example and say we have now invested. Jack has opted for option 1 and diversified his £20,000 in 10 shares equally.

Jane, on the other hand, has opted for option 2 and put her £20,000 in 2 shares equally.

Let’s now look at risk:reward in action.

Jack’s portfolio performs solidly – he realised a 10% gain across 5 of his shares, a 10% loss against 4, and one of his shares incredibly gained 500%. Jack’s portfolio is now worth £30,200.

Jane also happened to invest in the share that did 500%. However, her other share did not do well and she had to sell at a 30% loss. Jane’s portfolio is now worth £57,000.

Of course, we could give hundreds and thousands of permutations for these types of portfolios, but that would not be a fruitful use of time. The point I’m trying to make is that whilst Jack’s portfolio might be more resistant to losing money, he also wouldn’t gain much either simply because his money is too far spread out. Even though one of his shares did 500%, he ‘only’ realised a net 50% gain in his portfolio compared to Jane’s 285% and that was all down to his diversification.

Clearly, the downside for Jane would have been much more dramatic too. But that’s why I personally only invest in what I could afford to lose, because whilst £20,000, for example might not change Jane’s life, compounding her gains and turning that into the hundreds of thousands of pounds would change her life and set up a really strong springboard from which to work.

Diversification is for later

I really recommend reading this book. Although I read the relevant parts after I’d come to my own views, it was good to get ‘confirmation’ in a way to realise that I wasn’t totally barking mad.

In it, Allen talks about diversification being much like insurance. He argues, however, that you should only keep a small percentage of your assets in low-risk investments to give you something to fall back on if things go sour in your high-risk investments. This goes back to what I was saying earlier about only putting in what you can afford to lose.

He cites ‘the wealthiest of multimillionaires’, Carnegie, who said: ‘Put all your eggs in one basket, then watch that basket.’

And he nicely summed up my views on diversification and timing which needs no further comment from me at all: ‘There is a time to diversify and a time to concentrate. You pick a strong investment and throw your whole energy into it. Don’t dissipate your energy in a dozen different directions. Become an expert, and when you fail, learn from your failures; add this precious knowledge to your store-house and proceed to correct the mistake in the future.’

Final thoughts

So those are my thoughts on concentration of a portfolio versus diversification. I simply believe that concentration is more conducive to wealth creation; I also equally believe that diversification is strong and sensible, but is a defensive rather than offensive strategy. It does not facilitate wealth creation, but if you have already created wealth and are seeking to protect that wealth with minimal gains, diversification is wise.

I know Ibrahim will definitely have something to say, and I certainly look forward to the rest of your comments in the comments below!

Please note that the above does not constitute financial advice. You should seek the advice of a qualified, independent financial advisor for a qualified opinion. Never buy shares without conducting sufficient research.

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