Diversification – Good or Bad?

If you read books on investing like One Up on Wall Street you’ll hear about diversification. Peter Lynch has expressed his dislike of companies who diversify. He coined a term for the strategy “Diworseification.”

I wanted to discuss the idea of diversification because there are many great investors that say avoid it. Warren Buffett, Charlie Munger and Peter Lynch have all expressed the opinion diversification is bad. However, they themselves diversify their portfolios. It’s a contradiction.

Let’s start examining this contradiction by looking at Lynch’s chapter on “Diworseification.”

In One Up on Wall Street, Lynch says that you’ll often see managers of a successful business buying other businesses. Often those other businesses are not related to the original business. That’s when the good intentions of the managers begin to turn for the worse.

The dedicated deworseifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding.

Peter Lynch

Lynch describes Mobil Oil as an example of this “Diworseification.”

Mobil Oil had bought another diversified business called Marcor. It’s main business included a retail business and a container business called Container Corporation. It later sold the container business at a discount and bought Superior Oil for way too much. All this resulted in Mobil Oil’s stock rising only 10% during the oil rally of the 1980’s. Compare that to Exxon which doubled in the same time frame and it’s easy to understand the reluctance to diversify.

For every rule there is an exception

Now even though Lynch expressed a dislike for diversification when businesses do it, he had high regard for the practice when creating a portfolio.

It isn’t safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios I’d be comfortable owning between three and ten stocks.

Peter Lynch

He highlights the value of diversification for its ability to reduce risk. Even if you’ve done research there’s a chance that some event may take the value of a stock down. If you have 10 stocks and one of them runs into to trouble with the SEC, then at least the other 9 will reduce the loss of capital to your portfolio.

On the flip side, 1 of the 10 stocks might be a surprise winner. Lynch mentions Stop & Shop being a surprise 10-bagger that he only expected a 30-40% return.

Another benefit of diversification is the ability to increase the weighting to winners. If the story of a Turnaround stock changes to a Fast Grower story, then it makes sense to add more capital to that stock. Lynch expresses this as being an important part of his strategy.

In the end, it’s difficult to say with 100% certainty that diversification is good or bad. For myself, I’ve concentrated my capital into a dozen-or-so stocks. Lynch himself has a few wise words when it comes to the contradictions of diversification.

The point is not to rely on any fixed number of stocks but rather to investigate how good they are, on a case-by-case basis.

Peter Lynch

The longer I do this more I begin to see what he means. If you find a good business, invest in it. If you find ten good businesses then invest in all of them. The point is to find the good businesses and avoid the bad ones.