Principle #3: Quality over quantity

“Diversification is protection against ignorance. It makes little sense if you know what you are doing.” — Warren Buffet, Chairman and CEO of Berkshire Hathaway.

Photo by Abigail Keenan on Unsplash

The key to risk reduction lies in the expansion of your knowledge. This principle is not limited to investing, but it permeates all aspects of life. Given the inherent uncertainty of the future, every decision carries a potential for a negative outcome. The most effective strategy to tilt the odds in your favor is to amass more information about the decision at hand, rather than making numerous decisions.

To better illustrate this point, we first need to define risk. Most people define risk as the probability of absolute loss, but the more accurate and dynamic way to define risk is the probability of comparative loss. Comparative loss is how much is lost compared to your next best outcome, also called opportunity cost in economics. For example, when faced with where to attend college, by choosing one college, I am simultaneously choosing not to attend all other colleges. This means I may still “lose” even though I picked a good college since I am at risk of forgoing a great one. My comparative loss is the value I would have gained from the great college minus the value of the good college. When you analyze risk in this way, it quickly becomes apparent the way to mitigate this risk is not by attending every college in the country but rather by performing greater due diligence beforehand to increase your chances of picking the great college.

This might seem obvious when deciding which college to attend or when making other decisions like choosing who to marry or which house to buy. Yet strangely, when it comes to investing, people tend to discard the idea of comparative loss and return to investing in “a little bit of everything.” By investing in 100 stocks, you are indeed limiting your absolute loss. However, you risk not picking the one stock that will 100x its value. This is why the greatest investors have such concentrated portfolios; they understand true risk is found in the stocks they “could have picked but didn’t” and spend enormous amounts of time researching and gathering information on their small number of investments and less time trading or investing in broad indexes.

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If you are interested, below is a more detailed real-world example of how/why increased knowledge performs better than diversification in risk mitigation.

Betting on a sports game

Imagine I am offered an opportunity to place a 2:1 odds bet of $100 on the winner of a football game. In this scenario, the possible ending amounts of this bet look like the following:

• Pick loser: $0

• Refuse to bet: $100

• Pick winner: $300

When thinking about risk in terms of absolute losses, what you are risking based on each outcome looks like this:

• Pick loser: -$100

• Refuse to bet: $0

• Pick winner: $0

However, when thinking about risk in terms of comparative losses, what you are risking based on each outcome looks like this:

• Pick loser: -$300 (by picking the loser, you didn’t pick the winner and missed out on $300)

• Refuse to bet: -$200 (by not betting, you didn’t pick the winner and missed out on $200)

• Pick winner: $0 (by picking the winner, you took advantage of the opportunity given to you and suffered no losses)

Notice how, when looking at risk through the lens of comparative losses, you stand to lose much more by picking the loser or even refusing to bet than you observe when only considering absolute losses. In other words, risk defined by absolute loss fails to consider any upside in a decision (fear-based). Still, when you think about risk correctly, considering the upside, you begin to care a lot more about making the best choice vs avoiding the wrong choice (opportunity-based).

Now, let's consider some probabilities to determine the expected absolute losses of each choice. First, we assume we know nothing about either team, so we have a 50/50 chance of guessing the winner.

• Refuse to bet: $0 * 100% = $0

• Bet: (50% * -$100) + (50% * $0) = -$50

Here are the comparative expected losses:

• Refuse to bet: -$200 * 100% = -$200 (guaranteed to lose out on $200)

• Bet: (50% * -$300) + (50% * $0) = -$150

Notice that when thinking about absolute losses, the way to avoid risk is not to bet at all. However, placing a bet is less risky when looking at comparative losses.

Risk Mitigation Strategies (diversify or research):

Let's say you try to mitigate your risk by diversifying, putting $50 toward the bet, and keeping $50 out of the bet. The expected losses would look like the following:

• Refuse to bet: 50% * $0 = $0

• Bet: 50% * -$50 = -$25

• Total = -$25

And the comparative expected losses

• Refuse to bet: 50% * -$200 = -$100

• Bet: 50% * -$150 = -$75

• Total = -$175

See how, when diversifying, you lowered your absolute risk from -$50 to -$25 but increased your comparative risk from -$150 to -$175.

Now, let's consider that instead of diversifying, you spend time studying and getting to know each team. Doing so gave you insight that improved your odds of choosing the winning team to 70%. Below are the resulting expected absolute/comparative losses:

Absolute expected losses:

• Refuse to bet: $0 * 100% = $0

• Bet: (30% * -$100) + (70% * $0) = -$30

Comparative expected losses

• Refuse to bet: -$200 * 100% = -$200 (still guaranteed to lose out on $200)

• Bet: (30% * -$300) + (70% * $0) = -$90

By doing some research, you lowered your absolute risk from -$50 to -$30 AND lowered your comparative risk from -$150 to -$90.

When comparing the two strategies, you see that diversifying did a good job of decreasing your potential absolute loss; however, it failed miserably when attempting to mitigate comparative loss. By improving your odds through research, you can decrease your comparative risk (-$150 —> -$90) vs diversifying, which actually increases it (-$150 —> -$175)!