Today's menu:

• What is diversification?

• What are Warren and Charlie on about?

• I disagree with Warren and Charlie

• Extraordinary companies portfolio performance

• My lessons learnt

What is diversification?

In finance, if a single company faces a risk that is specific to it, that is called company-specific risk or diversifiable risk or unsystematic risk. An example of this would be the recent US government regulations that prevent semiconductor companies (like Nvidia) from selling their chips to China. That is a problem specific to them. It doesn’t affect any other company.

But there are also risks that everyone faces. This is called undiversifiable risk or systematic risk. Covid is an example of this - it affected all companies around the world.

(By the way, notice how finance dudes love using technical sounding words, to make finance seem more complicated).

The main takeaway is that there are two types of risk, those specific to a particular company and those that affect all companies.

The idea behind diversification is that if you own enough companies, you can cancel out the company specific risks (unsystematic risk). Then all that remains is the undiversifiable risk (systematic risk) and the market rewards you for bearing that risk.

If you owned every stock in the market, you would be well diversified, but it’s hard to own all the stocks in the market. Fortunately, finance dudes also figured out that if you own about 30 companies, you are fully diversified.

Diversification is actually a risk management strategy and we talked about it in one of our early newsletters. You can find that newsletter here.

Diversification doesn’t sound unreasonable, so what are Warren and Charlie on about?

What are Warren and Charlie on about?

The quotes interspersed through this article will tell you that Warren and Charlie are not fans of diversification.

But what Warren and Charlie really mean is that diversifying for the sake of diversifying is not a good idea. Why?

1. If you buy the entire market, your return will be the market return. You will not outperform the market.

2. Not every company is good. So, you don’t want to indiscriminately own all of them. But you and I already know this, that is why we are always looking for extraordinary companies.

Surprisingly, Warren and Charlie have benefited from diversification. Their holding company, Berkshire Hathaway owns more than 65 major subsidiaries and 36 stocks (worth $258 billion). They also own over $328 billion of US Treasury Bills.

That sounds pretty diversified.

They didn’t buy all these companies for the sake of diversification. They bought them because they were good investments. Nevertheless, they ended up fairly diversified and it benefits Berkshire shareholders because it reduces the risk that Berkshire will fail. Unfortunately, it also reduces the potential for big gains. It makes everything slow and steady.

I disagree with Charlie and Warren

Here's where I disagree with them.

I think it is dangerous for the average investor to take their diversification warnings at face value.

The average investor is not thinking about risk management, they are thinking about getting rich.

Imagine this - one day, the average investor decides to run a concentrated portfolio (i.e. only a few shares). They tell themselves Warren and Charlie don’t believe in diversification. They even have Peter Lynch’s book - One up on Wall Street, where he calls it “diworsification”.

Armed with these great sayings, they buy a few stocks which they have “researched”, and what happens?

They get onto a crazy roller coaster with big returns one day and big losses the next. That’s what happens when you own only a few stocks, the portfolio is volatile. This puts them into an emotional frenzy, especially on days when the market is down and their life savings are evaporating. Eventually, to calm their nerves, they sell out at the worst possible time. They leave the stock market poorer and emotionally worse for wear.

But I’m a tough investor you say, I can handle a few ups and downs.

Can you really?

Extraordinary companies portfolio

Here’s our Extraordinary Companies portfolio. About a year ago, we unintentionally concentrated our portfolio by taking two large positions. We bought Nvidia and Novo Nordisk. At their peak, these two companies totaled 67.5% of the portfolio.

What happened next?

Nvidia kept bucking like a bronco - as it does, and Novo Nordisk lost its darling status as Europe’s best company and promptly dropped 50%.

You can see all this in our portfolio.

Notice from July 2024 the line gets a lot more squiggly and goes up and down a lot more. That is volatility. For most people, it is very hard to live with.

But how is the portfolio doing?

It is actually doing quite well over the long-term. Since inception (almost 4 years ago) the portfolio has delivered 14.5% compound annual growth rate. For comparison, here's index returns in the same time period:

• Extraordinary Companies: 14.5% per annum

• World index: 7.98% per annum

• S&P 500: 9.62% per annum

The Extraordinary Companies portfolio has done exceptionally well, so what am I complaining about?

Look at the graph below. Over the past year, our portfolio has been proverbially body-slammed by the indexes - that is what I’m complaining about:

• Extraordinary Companies: 2.1%

• World index: 14.4%

• S&P 500: 13.4%

We are winning over the long-term, but we’ve given up ground over the past year. The very same year that coincides with us reducing diversification and concentrating the portfolio.

To explain, concentrating the portfolio was not a strategy that we were pursuing. At the time that we took the Nvidia and Novo positions, the plan was to increase the size of other positions too.

The problem is that as we analysed US stocks, we realised that their valuations were too high. So, we widened the search and looked for alternatives in Europe. But valuations were also high there. Before you know it, we’re in a tariff war - which you can see as the big dip in the graphs around April 2025. And here we are today.

My lessons learnt

How have I handled the volatility?

I’ve toughened up over the years, but it’s still not fun.

• Firstly, I knew I messed up, so I accepted that there is a wild ride ahead until I fix the portfolio.

• Secondly, as part of fixing things up, I used market volatility to add new positions in TSMC and Meta.

• Thirdly, I realised that diversification could help. I picked this up from our own ROA Watchlist portfolio.

Did you say diversification?

Conclusion

Yes, diversification but not diworsification (which is not a real word).

The ROA Watchlist portfolio is up 31.8% per year over 3-years and it contains 34 companies. That is a fully diversified portfolio - those companies are spread across multiple industries and geographies (the list of companies is here).

Not every company has done well. But that is the point of a diversified portfolio, it manages risk in a few ways. For example, Novo Nordisk is in the portfolio, but still the portfolio performs well because its company-specific risks have been diversified away and our portfolio exposure is managed (i.e. its weighting in the portfolio is small).

Risk management is the real benefit of diversification.

So, I disagree with Warren and Charlie on this one.

Diversification can work if you create a diverse portfolio of extraordinary companies.

Wait a second …. isn’t that exactly what Berkshire Hathaway is?

I would like to hear what you’re up to.

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