Background

In another chatgroup, there was an interesting discussion today about diversification.

Someone famously quoted Buffett who said "Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing."

I shared my own views there, and after the chat, I was curious what ChatGPT would say on this topic, so, I asked ChatGPT a few questions and here are its answers.

ChatGPT's opinions on diversification

Question 1 - ChatGPT, why do I need to diversify my stock portfolio?

Diversifying your stock portfolio is crucial for managing risk and enhancing potential returns. Here’s why:

1. Risk Reduction: By spreading your investments across different stocks, sectors, or asset classes, you reduce the impact of poor performance from any single investment. If one stock or sector underperforms, the overall effect on your portfolio is less severe if other investments are performing well.

2. Mitigating Volatility: Different stocks and sectors often react differently to market conditions. For example, technology stocks might perform well when the economy is strong but struggle during a downturn, whereas consumer staples might be more stable. Diversification helps smooth out the ups and downs of your portfolio.

3. Enhanced Returns: A diversified portfolio can capture gains from various segments of the market. While you may not benefit as much from the extraordinary performance of a single stock, your overall returns can be more stable and consistent.

4. Protection Against Unpredictability: Markets are unpredictable, and diversification helps protect against unforeseen events that might negatively impact specific investments. For example, if a company faces legal trouble or a sector faces regulatory changes, having investments in other areas can provide a buffer.

5. Long-Term Growth: Over the long term, diversified portfolios tend to perform better because they are less susceptible to the dramatic swings that can affect more concentrated portfolios. This can lead to more stable growth and a smoother investment journey.

In essence, diversification is like not putting all your eggs in one basket. It helps balance potential risks and rewards, making your investment strategy more resilient and adaptable to changing market conditions.

Question 2 - ChatGPT, why can't I concentrate on stocks I know?

Focusing solely on stocks you're familiar with might seem like a smart approach, but it comes with several limitations that can impact your investment success. Here’s why:

If you’re skilled at analyzing stocks and feel confident in your ability to pick winning investments, that’s a valuable asset. However, even the best analysts can face challenges that diversification helps mitigate. Here’s why diversification remains important, even with strong analytical skills:

The ideal number of stocks to hold for effective diversification can vary depending on several factors, such as your investment goals, risk tolerance, and investment strategy. However, there are some general guidelines that can help:

When diversifying your investment portfolio, it's important to establish criteria that align with your investment goals, risk tolerance, and strategy. Here are key criteria to consider for effective diversification:

The quote you’re referring to is often attributed to Warren Buffett, who famously said, “Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.” This statement reflects Buffett’s view on diversification as it relates to investing in individual stocks versus holding a broader range of investments.

Truth or Falsehood?

1. Context Matters:

   • Buffett’s Perspective: Warren Buffett is known for his focus on high-quality, well-researched investments. His approach suggests that if you thoroughly understand and can confidently assess a few companies or investments, concentrating your investments in those could yield higher returns. Buffett himself has often emphasized investing in what you know and understand deeply.

2. For the Average Investor:

   • Risk Management: For most individual investors, diversification is a key strategy for managing risk. The average investor may not have the time or expertise to deeply analyze and continuously monitor a small number of stocks. Diversification helps spread risk across a broader range of investments, which can help reduce the impact of poor performance in any single investment.

3. Diversification vs. Concentration:

   • Different Strategies: Diversification is a strategy aimed at reducing risk by investing in a variety of assets. It’s a common and prudent approach for many investors, particularly those who may not have the resources or expertise to pick individual stocks with high conviction.
   • Concentration: Conversely, concentrated investing involves putting a larger portion of your capital into a smaller number of investments that you believe in strongly. This approach can potentially yield higher returns but also comes with higher risk, as poor performance in a single investment can significantly impact your overall portfolio.

4. Middle Ground:

   • Balance: For most investors, a balance between diversification and concentration is ideal. Diversifying across different sectors, industries, and asset classes while also maintaining some focus on a few well-researched investments can provide both risk management and the opportunity for higher returns.

In essence, the view that diversification is only for those who don’t know what they’re doing is not entirely accurate. Diversification is a foundational principle of risk management and is widely used by both individual and institutional investors. However, for experienced investors who have a deep understanding of their investments, a more concentrated approach may be appropriate, though it carries its own set of risks. The key is to find a strategy that aligns with your investment knowledge, risk tolerance, and goals.

Summary and Conclusion

So, what's your takeaway from listening to ChatGPT?

I find its answers fascinating.  Surprisingly, quite aligned with my own personal views.  Hard to pinpoint one view where I strongly disagree.  Maybe 20-30 stocks.  I find 30 is still not sufficiently diversified across so many different areas.  I have closer to 50, but I can manage 50 quite easily and if you can't, then, try to find the right balance.

My beliefs on diversification is cemented after a terrible personal experience.  People change when they are forced to change and it's the same with me.  Prior to that, I believed so much in this wonderful stock called "AIG" (American International Group).  My beliefs is grounded on facts, both fundamentals and technicals.  From the 1970s till 2007, AIG stock price is everybody's dream, regardless of what type of investor and trader you are, whether fundamental, technical, hybrid, etc.   Fundamentally, the business kept delivering steady returns year after year after year.  Technically, the chart is perfect throughout these 3 decades.  See the price chart of AIG during this period.

For you to understand how consistent and how good it is over 3 decades, it turned $10 into nearly $2000!  Definitely over 100 bagger!  

Additionally, during this period:

• All analysts and institutional investors only have good things to say about this stock year after year - for over 3 decades.  Can you imagine this?  
• Rating agencies like Moody's, Standard & Poors concurred with these IBs with only good things to say about AIG.  Nobody had bad things to say.

And unfortunately for me, by 2007, I believed it so much, that like so many people then, I had allowed 35% of my entire net worth in that one  stock.  I failed to consider that I might not have diversified as much as I should.

And what transpired in a very short time during the GFC?  It fell faster than I could react.  Complete disbelief how 3 decades of growth turned into a huge disaster in just one year, wiping out 99% of its value!!!  Remember, AIG was a Dow Jones component, the best stock globally, viewed and analyzed by every analyst globally!  Here's what the chart looked like.

I remembered the market was in huge disbelief.  

I was in huge disbelief.  

After all, I "knew" the fundamentals of AIG best compared to all stocks.  The charts also.

Yet, as it turned out, my knowledge was limited.  My data was limited.  The whole world's data was limited.

As what ChatGPT says - all analysis have limitations.

Later on, I discovered the knowledge gaps.  Of course by then it was too late.  More than a third of my entire Net Worth was wiped out permanently, because I did not diversify sufficiently.  

It was a super expensive lesson.

What was the lesson?  Diversification.  After that huge loss, I resolved never to ever again subject myself to concentration.

In short - diversify especially when you have only another 10-20 years to retirement and if you are now in your 40s and definitely in your 50s and a must as you enter 60.  Because all analysis have limitations.  No matter how good an analyst you are, markets are unpredictable and re-read the good advise from above.

Disclaimer:  As usual, you are solely responsible for your own trading and investing decisions.