Diversify but Focus

“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
-Warren Buffett

Warren Buffett has long been an advocate of index funds for investors lacking knowledge and/or experience. Index funds are the poster children of diversification. They are the least risky investment alternative for retail investors because nobody beats the market, including professionals with more than a 90% failure rate.  

Warren Buffett is suggesting that retail investors shouldn’t be active investors. They should be passive investors by buying an index fund and letting it ride. Diversification reduces risk by spreading capital across a variety of companies in different sectors. 
What better way to diversify across various industries and market sectors than to invest in an S&P 500 index fund? For the uninitiated, the S&P 500 is a stock market index that tracks the performance of about 500 companies in the U.S. across 11 market sectors that offer a pretty good snapshot of the stock market’s health. Want easy diversification? Invest in an index fund.  

Here’s the problem with investing in an index fund or creating your diversified portfolio through your efforts. When you diversify in the public markets, all you’re doing is tracking the performance of the stock market and the broader economy. The purpose of diversification is to mitigate risk, but you can’t mitigate away market downturns. Think about it this way. If you put your eggs in different baskets, you may avoid all your eggs being smashed had you put them all in one basket, but what happens when the whole warehouse where you keep these baskets goes up in flames? Diversification is nullified, just like it was with the dot-com bubble, the Great Recession, and most recently, the pandemic-induced recession.  
Over the long long-haul (30+ years), the S&P 500 will deliver a positive return, but there will be bear markets interspersed across this timeline where your portfolio will take devastating hits. The result is watered-down returns. That’s why nobody ever got rich from index funds or a diversified stock portfolio. It’s a long-term portfolio preservation play, not a wealth-building formula.  

The ultra-wealthy diversify differently. Their goal isn’t to preserve the portfolio. It’s to maintain the income, appreciation, and tax benefits associated with the types of assets they’re interested in.  
What type of assets are the ultra-wealthy interested in? Not public stocks? Whereas the average retail investor allocates a majority of their portfolio to stocks, the ultra-wealthy allocate to alternative investments only found in the private markets.  
Take a look at the private alternative investments the ultra-wealthy allocate too.

• Passive cash flow
• Appreciation
• Tax benefits
• Insulation from market volatility
• Hedge against inflation

The two most prominent assets in an ultra-wealthy person’s portfolio are equity investments in private companies (i.e., private equity) and real estate. The wealthy are heavily invested in private equity and real estate not only because of their tangible natures (you can touch and feel them) but for the following advantages as well:

• Passive cash flow
• Appreciation
• Tax benefits
• Insulation from market volatility
• Hedge against inflation

For the ultra-wealthy, the goal of diversification isn’t some broad-based strategy to mitigate risk; the goal is to preserve the cash flow and appreciation needed for wealth building. Nobody has ever gotten wealthy from stock market diversification, but many investors have benefited from focused, private market diversification. How?  

By focusing on preserving cash flow and appreciation, the ultra-wealthy are preserving the two most important factors for creating, growing, and maintaining wealth.

“Diversification may preserve wealth, but concentration builds wealth.”
– Warren Buffett

Traditional diversification maintains the status quo. Focusing on specific assets that perform particular functions like cash flow and growth ensures wealth-building perpetuates.
Passive private investments offer perfect opportunities to diversify across various variables to preserve cash and growth in tangible assets like private businesses and real estate. The variables that can be used in a diversification strategy include 1) asset segment, 2) stage of development, 3) security type, 4) type of return, 5) holding period, and 6) geographic location.

A portfolio spread out across the preceding six variables will protect against downturns. If one asset falters, the income from the other nine will compensate to ensure continued cash flow.
Broad diversification in the public markets won’t make you rich. Focused diversification on cash-flowing tangible assets that appreciate over time will.  

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