Why It’s Time to Forget the “Golden Rule” of Investing

Shah Gilani|August 16, 2024

In the investing world, diversification is often hailed as the quintessential strategy for reducing risk without compromising returns.

The adage “don’t put all your eggs in one basket” has become a foundational piece of advice for both novice and seasoned investors.

However, if you delve deeper into the mechanics of successful investing, you’ll see that diversification – at least the way most investors do it – is not the inviolable rule it’s cracked up to be.

Having spent decades in the trenches of Wall Street, navigating the highs and lows of markets with a perspective that often runs counter to mainstream advice, I advocate for a different approach…

Instead of grossly spreading investments to reduce risk, simply concentrate on your best ideas to maximize returns.

To some, that may seem like a crazy idea. Yet it’s been wildly successful – not just for me, but for the world’s most famous investors.

Stop Watering Down Your Wins

Diversification, by definition, involves spreading your investments across various assets. The goal is to mitigate risks associated with any single investment.

While this approach technically reduces volatility and provides a safety net during downturns, it also dilutes potential returns. Over-diversification can lead to mediocre outcomes, watering down the impact of truly outstanding investments.

In contrast, many of the world’s most successful investors have shown a penchant for concentrated investments when they have high conviction in their choices.

They understand that true wealth is created by concentrating capital in a handful of positions that have the potential for extraordinary returns.

Warren Buffett and Stanley Druckenmiller, two titans of the investment world, employ strategies that emphasize concentration over diversification.

Listen to the Oracle of Omaha

Buffett is renowned for his focused investment philosophy. He has critiqued mindless diversification, famously saying, “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”

This perspective comes from a man who has built a vast fortune. And he has built it largely through concentrated bets on companies he believes have durable competitive advantages and strong management teams.

He raised eyebrows recently when he sold off his Apple (AAPL) shares – a position he held for many years. But for our purposes today, let’s remember how Buffett first took a massive stake in the company, sitting on shares as they climbed more than 700%.

Rather than spreading his investment across the technology sector, Buffett placed a significant bet on Apple because he believed in the company’s ecosystem and its ability to generate substantial cash flow.

Over the years that followed, this concentrated position paid off handsomely, contributing significantly to the performance of Buffett’s multibillion-dollar portfolio.

Why Druckenmiller Bets Big

Stanley Druckenmiller, the legendary hedge fund manager known for his macro trading prowess, took a similar path. He has often advocated for a concentrated investment strategy when high conviction aligns with favorable market conditions.

Druckenmiller’s approach is dynamic, scaling up his exposure in trades where his confidence level is high. This method was instrumental in his famous bet against the British Pound in 1992, when he ran George Soros’ hedge fund.

The move famously resulted in a massive payoff, the first-ever $1 billion profit on a single trade.

Druckenmiller’s philosophy revolves around “making large bets on a small number of ideas” when he sees exceptional opportunities. It underscores a critical element in any successful investment strategy…

High conviction in one’s analysis and market understanding can justify a concentrated position, potentially leading to outsized returns.

Own the Right Things

At the core of my own investment philosophy is the belief that conviction and concentration are crucial for achieving superior returns.

High conviction investing means doing your homework, understanding the ins and outs of every trade, of every investment, and having a clear rationale for why it stands out from the crowd.

It’s about quality over quantity.

For individual investors, this means identifying your best ideas – whether they be stocks, sectors, or positioning yourself in alternative asset-classes – and allocating capital with the confidence that these choices will perform well over time.

It’s not about owning a bit of everything… it’s about owning the right things in the right proportions.

Implementing a concentrated investment strategy requires thorough research, continuous monitoring, and an unshakeable belief in your trade or investment thesis. It also requires a well-calibrated risk management framework to protect against unforeseen events.

To be clear, this approach is not for everyone. It demands deep market knowledge, a robust analytical capability, and, most importantly, the emotional discipline to stick with your convictions even in volatile markets.

That last part can be especially tough for the average investor.

While diversification is not without some merit, particularly for those who are not professionals, its status as the golden rule of investing deserves critical scrutiny.

For those equipped with deep market insights and a disciplined investment approach, concentration and conviction almost always leads to far greater rewards.

As markets evolve and brand-new opportunities arise, embracing a strategy that aligns more with the practices of the world’s top investors – and yours truly – could be your key to unlocking significant wealth.