The Right Investment Strategy – Diversification or Concentration?

Any investor researching strategies quickly stumbles upon two different approaches: diversification and concentration. The former focuses on spreading portfolio risk among several different capital investments. The latter focuses on a maximum return by concentrating available capital on the most successful capital investment.

Which strategy is best depends on whether the investor assumes a certain or uncertain future. Those who believe in a certain future believe that they can predict the development of an investment through knowledge and experience. In this case, it is worthwhile identifying the most promising investments and to invest an optimal amount in them.

On the other hand, those who believe in an uncertain future are of the opinion that unexpected factors always affect the development of a financial investment. In this case, dividing the available capital among investments in a variety of areas is advisable, as it minimizes the risk of loss and increases long-term chances of success.

Diversification and portfolio theory

One way to minimize the risk of loss is by spreading risks. The available capital is divided among investment objects from a variety of economic sectors that differ both in terms of risk and of potential return. This prevents all of the investor’s assets from simultaneously losing their value in the event of an unexpected crisis in one industry or market segment. This strategy is called diversification.

Diversification is derived from modern portfolio theory, a subcategory of capital market theory. To this day, it is the basis for investment decisions made by large insurances, hedge funds, and asset managers. It was developed by the economist and Nobel laureate Harry Max Markowitz. In the 50s, the economist from Chicago provided empirical evidence that a diversified portfolio is superior to any individual investment in terms of the ratio between opportunity and risk. According to Markowitz, this remains true no matter how well the individual investment was selected.

According to portfolio theory, the different investments – mostly securities, but also real estate and precious metals – should never be considered individually in relation to potential returns and risk, but always in relation to one another. After all, each investment has an influence on the value development of the entire portfolio. This is called correlation of the investments. When they correlate positively, both values move in the same direction; in case of a negative correlation, they go in the opposite direction.

Positive correlations should be avoided as much as possible for a well-diversified portfolio. A study by the US economist Peter Bernstein in 2000 entitled “Risk Management, Financial Markets and Insurance: The Hidden Linkages” showed that diversification can make a significant contribution to reducing risk. According to his findings, it can reduce portfolio risk by 25-30%.

Private investors wishing to diversify within the same asset class should weight all positions equally just in case. Speculative bets such as the future development of a particular market should be avoided. In the long run, incorrect forecasts pose the greatest risk of poor portfolio performance overall.

Furthermore, investors should develop a long-term strategy and be disciplined in sticking to it. Although good selection and weighting of individual investments can be very relevant in the short term, both only have a limited influence on value development in the long term. Bernstein comments on this: “If they are 10 or 20 percent behind what retrospectively was the best distribution, then you haven't lost that much.”

Concentration and value investing

Investors who assume a certain future achieve the best results by placing all their money in the most successful asset. This is called concentration or concentration strategy. When an investor is absolutely certain about the performance of an investment, the concentration of capital on this investment leads to the highest return. This perspective considers risk diversification as dilution of return. It looks at return on a financial investment in the long term and does not refer to short-term fluctuations in value.

This strategy is also referred to as value investing. The pioneer of value investing is the economist Benjamin Graham. In 1934, he and his colleague David Dodd published their book “Security Analysis,” which provided the intellectual foundation of value investing. The most famous representative of this investment strategy is Warren Buffet, one of the most successful investors of all times. Buffet is a declared opponent of diversification and once called this approach a “protection from lack of knowledge” that doesn’t make sense when one has the necessary knowledge.

What are the characteristics of value investing? First of all, investors who follow this approach only invest in companies and industries whose business models they can understand. They look for undervalued companies in these areas. They conduct a detailed equity analysis – also known as fundamental analysis – to determine the intrinsic value of a company. If this value is lower than the valuation at which the company is currently traded on the stock exchange, the value investor buys the company shares and holds them until the "true value" of the company has been reached.

Therefore, value investing is a long-term strategy that requires a great deal of patience and extensive knowledge of equity analysis. A value investor often has to wait years for the best buying opportunity to acquire a company with outstanding management and a solid business model at the best price. It also requires the courage to view price falls on the stock market as a buying opportunity rather than a selling point like other investors do. Value investors must be prepared to swim against the tide and take high risks. This is the only way to achieve the above-average returns that Warren Buffett and Berkshire Hathaway, for example, achieve every year.

Diversification in times of low-interest rates

It may be worthwhile for professional investors to identify and only bet on undervalued stocks. However, this usually involves too much effort for private investors. It requires not only a high degree of expertise but also a lot of investment experience and patience. It is not without reason that Warren Buffett employs a whole army of lawyers, tax advisors, and financial experts to test every potential investment for his investment company Berkshire Hathaway.

As such, diversification is the safer strategy for private investors. Which areas to pursue diversification in is the question. Challenges are the prevailing low-interest rate and the disrupted pricing of the financial markets. Daniel Steltner, who worked as a management consultant at Boston Consulting Group for many years and now writes a column about the financial markets for Wirtschaftswoche, points out that the prices of assets – especially government bonds and equities – are heavily distorted by the expansive monetary policy of issuing banks. 

The largest central banks – the European Central Bank, the Bank of Japan and the Federal Reserve – currently own around 20% of all government bonds, considerably distorting the interest rates on these bonds. “When the interest rate level is manipulated, the prices of other assets are no longer accurate. Everything seems ‘cheap’ compared to government bonds,” says Steltner. Central banks have also invested in corporate bonds, equities, and index funds. The Bank of Japan owns about 3% of the Japanese stock exchange and has also purchased ETFs with a volume of USD 127 billion. The Swiss central bank has also invested around EUR 80 billion in US stocks such as Apple, Microsoft, Amazon, and Facebook. This naturally has an impact on stock prices on global stock exchanges.

What should private investors do in light of these distortions? Steltner gives the following advice: “Not buying anything just because prices are manipulated is not a good strategy. We have to accept that the authority of the central banks and confidence in the prevailing monetary system will be ruined at the end of this game. Money will probably be the worst investment in the end. In the meantime, however, increased liquidity should provide an opportunity to make targeted purchases in the event of corrections on the markets. I still maintain my recommendation to hold 25% each in gold, equities, real estate and liquidity.”

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