Why You Shouldn’t Diversify Your Investments

Diversification is the closest most investors get to a free lunch. But there is a point where spreading your money thinner stops reducing risk and starts diluting returns.

Some of the most successful investors in history have argued against diversification. Warren Buffett once told Berkshire Hathaway shareholders he would be perfectly happy owning just five stocks, provided he understood each one deeply. His top five holdings account for roughly 70 percent of the Berkshire equity portfolio. Apple alone makes up more than a quarter.

There is an argument for understanding where diversification helps, where it stops helping, and where it actively works against you. Most New Zealand investors are not under-diversified. They are over-diversified: paying multiple layers of fees on overlapping funds, holding what amounts to three versions of the same portfolio, and assuming more holdings automatically means less risk. The weight of the evidence suggests otherwise.

The case against broad diversification

The strongest argument against broad diversification comes from the data itself. Hendrik Bessembinder, a finance professor at Arizona State University, studied every US stock listed between 1926 and 2016. His finding was striking: just 4 percent of listed companies were responsible for all of the net wealth created above Treasury bills over those 90 years. The remaining 96 percent collectively matched, or fell short of, the return you could have earned from government bonds.

In other words, most stocks are mediocre. A small number of exceptional businesses generate the vast majority of long-term returns. If you own hundreds or thousands of them through broad index exposure, you will inevitably hold a large proportion of companies adding little or no value to your portfolio.

This is a global phenomenon. On the NZX, the pattern is visible in real time. In 2024, 61 percent of S&P/NZX 50 constituents underperformed the index itself. As is typical in capital-weighted indices, a minority of large winners drove most of the returns. An index fund tracking the NZX 50 forces you to own every company in it, including names with long records of disappointing shareholders. We have explored this in detail in our guide to index funds, which examines why passive investing from New Zealand involves a different set of trade-offs than the US data suggests.

Buffett has been making this point for decades. So have other prominent investors, including George Soros and Charlie Munger. These examples are illustrative, not prescriptive: the point is to understand their reasoning. If you have done the research and genuinely understand a business, spreading your capital across dozens of alternatives you understand less well is not prudence. It is a confession you lack conviction.

Modern Portfolio Theory supports a version of this argument, though not quite the way the concentration advocates frame it. The diminishing marginal benefit of diversification kicks in relatively quickly. Research consistently shows most of the risk reduction from owning multiple stocks is captured within the first 20 to 30 holdings. Adding a 50th, 100th, or 500th stock contributes almost nothing to risk reduction while steadily diluting the contribution of your best ideas.

Why concentration still isn’t right for most people

The concentration argument is intellectually appealing. It is also highly selective in the evidence it presents.

Yes, Buffett runs a concentrated portfolio. He has also said, repeatedly, he believes most investors should buy a low-cost index fund covering a broad slice of the market. He recognises the approach suited to a professional with 60 years of full-time investing experience is not the same one suited to a dentist in Takapuna or an engineer in Christchurch with a career to run and a family to raise.

The Bessembinder data cuts both ways, too. If only 4 percent of stocks create all the wealth, then picking the right ones in advance is extraordinarily difficult. The study is equally an argument for broad diversification, because owning the whole market guarantees you hold those 4 percent. Owning 10 stocks gives you roughly a one-in-three chance of missing every single one of them.

Concentration also demands a particular temperament. A focused portfolio of five to ten stocks can easily fall 40 or 50 percent in a bad year. For most investors, the risk is abandoning the plan at exactly the wrong moment because the pain becomes unbearable.

New Zealand has a concrete illustration of this. When COVID-19 hit in early 2020, research commissioned by the Financial Markets Authority found over 70 percent of KiwiSaver switching activity moved members into lower-risk funds. The value of money shifted to conservative funds during that period was $1.2 billion. The value switched back was just $121 million. Most never returned to their growth fund. Westpac estimated the cost to a single median-wage member who switched and stayed put at over $225,000 across 30 years. The trigger was a pandemic, but the pattern repeats whenever markets fall sharply. Any investor considering concentration needs to be honest about whether they could sit through a 40 percent drawdown without acting.

Wondering whether your portfolio has more overlap than you realise? A second set of eyes can help. Book a portfolio review.

The real enemy: over-diversification

If concentration is one extreme and mindless diversification is the other, the sweet spot sits somewhere between.

Peter Lynch, who ran the Fidelity Magellan Fund through one of the most successful periods in mutual fund history, coined a useful term for the wrong kind of diversification: “diworsification.” This is the practice of adding holdings because they make the investor feel safer. The result is a bloated collection of overlapping positions, potentially higher fees, and returns pulled relentlessly towards the average.

This is surprisingly common among New Zealand investors. Consider a realistic example. An investor with KiwiSaver or a similar managed fund holds a Growth fund with roughly 80 percent in global and Australasian equities. Alongside it, they hold an unlocked global shares managed fund through an investment platform. They also own a handful of NZX-listed shares directly. On paper, this looks diversified across three separate vehicles. Underneath, the actual equity exposure might be 80 to 85 percent global equities once you account for the overlap between the KiwiSaver Scheme and the managed fund, both of which are likely to hold large weightings in the same US and European companies. The NZX shares may duplicate positions already inside both funds.

Each of these vehicles typically sits within its own PIE structure, carrying a separate management fee. PIE structures are not always as efficient as they appear at face value, and holding multiple funds with overlapping mandates means paying separate fee layers on substantially the same underlying holdings. The supposed diversification across accounts is costing real money without adding genuine breadth.

Add a rental property to this picture and the concentration can become even more pronounced. A large share of net worth sits in a single illiquid asset, in a single city, in a single country.

We see this pattern regularly across our client base. People who believe they are well diversified often hold what amounts to several slightly different versions of the same portfolio.

When it genuinely makes sense not to diversify

There are a handful of situations where deliberately avoiding diversification is reasonable.

If the amount at stake is small enough to be inconsequential, concentration is fine. An investor putting a few hundred dollars into a company they find interesting through a share trading app is not taking a meaningful risk, regardless of how concentrated the position is.

Small business owners reinvesting profits into their own companies are making a concentrated bet, but a calculated one. They typically have more information and control than they would as a passive shareholder in someone else’s business. The same logic applies to short-term savers building a house deposit: cash or term deposits are the right call when the time horizon is 12 to 18 months, even though the position is undiversified.

And there are genuinely skilled professional investors who run concentrated portfolios for a living. They are far rarer than the investing commentary suggests, and the key distinction is they do it full-time, with deep research capabilities and the psychological resilience forged through years of experience.

Getting diversification right

For most New Zealand investors, the question is how to diversify well.

Adequate diversification means spreading capital across genuinely different asset classes, geographies, and sectors. The Bessembinder research tells us returns in equity markets are driven by a small number of exceptional companies, but it also tells us identifying those companies in advance is profoundly difficult. Broad market exposure captures those winners by default. For NZ investors, this also means being thoughtful about offshore diversification, particularly where holdings cross the FIF threshold and introduce additional tax considerations worth understanding before adding more international funds to the mix.

The practical steps are straightforward. Audit what you already own. Check whether your KiwiSaver Scheme, managed fund, and any direct holdings are genuinely giving you exposure to different things, or whether you are paying multiple fee layers for substantially the same underlying investments. Consider whether your overall allocation across shares, bonds, property, and cash reflects your time horizon and tolerance for volatility, not just what felt right when you first set it up. And revisit these decisions periodically, because both markets and personal circumstances change.

Diversification done right

The critics of diversification are not wrong, exactly. They are right about diminishing returns, mediocre holdings, and the cost of overlap. Where they go astray is in assuming their own skill and temperament are typical. They are not. The goal is adequate diversification, done well, with full awareness of what you own and what you are paying for it.

If you’d like a second opinion on how your investments are structured, especially if you’ve accumulated them gradually over time, book a financial health check.