Why ‘diversifying’ like Warren Buffett can boost your ISA returns

The Motley Fool
close-up photo of investor Warren Buffett
close-up photo of investor Warren Buffett

The term diversification is often thrown around in investing advice, but the big secret you don’t hear from successful investors is that a lot of them don’t do it. I think that diversification advice is so common because it sounds like the right thing to say. The stock market is too complex to explain in an article or a short video so commentators will simply advise you to invest your money in different assets.

Spreading the risk?

Diversification has its pros and cons. It reduces risk by spreading it around. But it encourages you to invest in assets/shares that you know little about too. An investor who focuses on a range of assets will likely know less about each of them than a specialist in a couple of areas. Therefore the investor could perform worse but console themselves that they are exposed to less risk overall.

While it is true that diversification reduces risk in the short term, over the long term returns should even out. At this point it becomes a disadvantage as you may miss out on the big returns because you have invested in sub-optimal investments that you lacked knowledge about. I think it’s significant that Warren Buffett says “diversification is protection against ignorance. It makes little sense if you know what you are doing”. In other words if you know about an industry or a market, it doesn’t make sense to invest in something that you know less about just because it is different.

Do as I say not as I do

A lot of successful investors give advice that they do not follow. Even Buffett recommends that private investors buy a low cost S&P tracker fund which will give you returns that closely replicate the performance of the American stock market. Yet he does not follow this approach himself. He invests heavily in American companies that he likes and is familiar with.

If a friend asked me how to invest in the stock market I would recommend a tracker fund because, if I outline my strategy, then their investing style would be a poor imitation of mine. Their best chance to beat the market would be to find a specialist area that suits their personality and research it throughly.

All on black

This doesn’t mean that I think you should invest all of your money in the one stock that you are most optimistic about. There is always a chance that a single event could wipe out all of your savings. Also it’s not good for your sanity to watch your life savings rest on the performance of one company. I personally subscribe to the idea that around 10 stocks allows me to focus on these stocks without exposing too much of my portfolio to a single event or a bad call.

Many new investors don’t realise how closely linked different financial markets are and diversify across shares that are actually highly correlated. I would therefore rather invest in shares (preferably through a stocks and shares ISA to cut my tax bill) that I know well than across a range of assets, but this is only because I am willing to put in the time and effort. Like Buffett, I wouldn’t recommend to a friend that they do the same.

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