Diworsification
The Hidden Cost of Over-Diversification
Feb 10, 2025
As investors, we are often told that diversification is the key to reducing risk and ensuring long-term success. The idea of spreading investments across multiple stocks, sectors, and asset classes is a well-worn piece of wisdom in financial circles. But what happens when diversification turns into "diworsification"—a dilution of returns due to over-diversifying into lower-quality opportunities?
For many investors, the struggle lies in deciding whether to bet big on their highest-conviction ideas or to spread capital across multiple holdings, even those with less conviction. This is a challenge I personally faced when analyzing small-cap software companies across the U.S., Canada, Sweden, the U.K., and Australia. My goal was to find businesses that fit within my circle of competence, offering strong fundamentals and long-term growth potential. What surprised me, however, was just how few companies met my criteria.
One company that stood out was VitalHub—a small-cap software business that I had deep conviction in. The business model, market opportunity, management/board and execution made it an attractive investment. But the question arose: should I concentrate my capital in my best idea, or should I diversify into lower-conviction names just for the sake of spreading risk?
For anyone following my portfolio updates you can see the concept of diversification vs. diworsification is very tough in practice.
The Myth of Diversification for the Sake of It
Many investors fall into the trap of diworsification, believing that adding more stocks to a portfolio automatically reduces risk. However, diversification only works if the additional investments offer truly independent and strong risk-adjusted returns. Owning ten stocks that you don't fully believe in doesn't necessarily make a portfolio safer—it often just waters down the potential gains from your best idea.
Peter Lynch famously said, "Owning stocks is like having children. Don't have more than you can handle." If you find a company that meets all your criteria, offers a durable competitive advantage, and is trading at an attractive valuation, why not allocate more capital to it?
The Opportunity Cost of Spreading Too Thin
By over-diversifying, investors often allocate capital to weaker ideas simply to reduce concentration risk. But this comes at the opportunity cost of diluting returns. If an investor strongly believes in a business and its long-term trajectory, a concentrated position can lead to outsized returns, assuming proper risk management.
Take legendary investors like Warren Buffett and Charlie Munger, who have consistently advocated for a focused investment approach. Buffett's famous advice to "keep all your eggs in one basket and watch that basket very carefully" highlights the importance of conviction over blind diversification.
Finding the Right Balance
This doesn’t mean investors should put everything into a single stock without careful analysis. Instead, it’s about finding the right balance between concentration and risk management. Some factors to consider include:
Your Level of Conviction – If you’ve done extensive research and understand a company’s risks and upside better than most, a higher allocation might be justified.
Downside Protection – Even the best ideas can go wrong. Understanding the downside risks and ensuring a margin of safety is crucial.
Portfolio Construction – Holding a small number of high-conviction names can still be diversified if they operate in different industries or geographies.
Liquidity and Volatility – Small-cap stocks can be volatile, so position sizing should reflect your ability to withstand drawdowns.
Final Thoughts
At the end of the day, investing is about making the best risk-adjusted decisions. If a high-conviction opportunity like VitalHub offers the best potential return, then concentrating capital in it—rather than diworsifying into weaker names—could be the smarter move. But doing so requires discipline, ongoing research, and the ability to stomach volatility.
Successful investing isn’t about owning the most stocks—it’s about owning the right stocks. Focus on quality, conviction, and careful risk assessment, and avoid diworsification just for the sake of spreading your bets.