Specialization vs. Diversification: The Investment Dilemma

In this episode, we continue the discussion on the diversification heuristic, noting people are naturally good at diversifying but can mistakenly believe they’re diversified when holdings overlap. 

We explores when it might make sense not to diversify, inspired by millionaire profiles that often focus heavily on one area such as real estate, which can be risky when leverage is involved. 

Here we propose a framework: Diversify when you’re uncertain, but consider concentrating when you have special knowledge within a “circle of competence,” echoing Warren Buffett’s view that diversification protects against ignorance. 

The challenge is knowing whether you’re truly specialized, since people are poor judges of their abilities due to overconfidence and the Dunning-Kruger effect. We outline Dunning-Kruger’s four stages and suggests using feedback and time/experience to better gauge competence before concentrating.

Transcript

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SPEAKER_00 0:04

Welcome to the Brian Fultis Behavioral Finance Podcast, where we unravel the mysteries of behavioral finance and unlock the secrets to making smarter, more informed decisions with your money. Now, here's your host, Dr. Brian Fultis.

SPEAKER_01 0:26

I'm super excited to continue to have this conversation about a mental shortcut or heuristic that we're actually good at called the diversification heuristic. And so last week we've learned that we're naturally quite good at diversifying. And this comes from a long history of wanting different sources of food and different ways we hunt, and brings us into how we naturally diversify our own food today and our music and our friends. And we also learned that it can also get in our way and make help us make some bad decisions, where sometimes we think that we're diversified, even though we're just overlapping our similar investments. And but nevertheless, we're going to keep continuing to take away the fact that we're actually pretty naturally good at that. And um, if we can be aware of when it is harming us, well, then we can kind of pivot out of those bad decisions and lead us into some better ones. But here's a question that I've been wrestling with, and this is our sequel to last week's episode: is there a point where it makes sense not to diversify? And I've been wrestling back and forth with this question as I continue to do my own research, and I also am looking at profiles of other people who have been successful financially. One of my favorite podcasts that I like to listen to, and I'm so sad that they uh have stopped recording, is this podcast called Millionaires Unveiled. And basically, it follows the same process of talking to people who are net worth millionaires, and that ranges anywhere from just under a million dollars to hundreds of millions of dollars, and getting them to tell their story and what they came from, how they built up, and what they are currently doing with this net worth of over a million dollars. And a lot of the times when I would listen to these stories, I noticed a trend of a lot of people, they had their thing. It would always be their thing. And a lot of the times it was real estate, and they had their real estate thing, and it was making them a lot of money. And when you think about this from a diversification standpoint, you my tendency was to think, oh wow, that that's really good for them. I understand real estate as an asset class, all the benefits of that, but my God, is he where's the diversification in this? Is there any hedging? Because if this guy is building his real estate business and he's putting 10% down on these houses, does he not realize that if the real estate market were to pull back 10%, he's out 100% based on the leverage that he has in his company? And so it seems like this sometimes this blind awareness of people's own portfolio. And so I had that. But then on the other hand, you go, okay, wait a minute. Somebody is specialized in in real estate, let's say, or they have their own business. That makes sense for them to position their portfolios into what they're specialized in and what they are good at. So how do you disentangle this? Um, that that was my conversation that I'd been trying to untangle here uh for quite a while. And so I I think I have a framework here that I want to share with you. And here are the two competing heuristics. Here are the two competing uh conflicts here. Diversification happens when we are uncertain about something. And when we are certain or have some special knowledge, then maybe we should be able to concentrate our portfolios. So if I'm going back to this potluck where there's all sorts of good foods spread out, and I don't have a good understanding of what is actually good, I'm gonna lean into that natural tendency to diversify and gain a little bit of knowledge over time. But by the time I get to that second or third plate, I'm starting to concentrate more into the things that taste better. Furthermore, let's assume that I have full knowledge of what's out there, and I know that there's a whole table of lobster and filet mignons uh and this really nice food. Does it make sense to say, yeah, yeah, yeah, but maybe I'm missing out? No, I'm gonna just gobble that up before everybody else catches on. So again, it leads me to this conversation of okay, when you are uncertain about something, it makes a lot of sense to diversify. When you are specialized, that is your green light to move into a more concentrated portfolio. Warren Buffett actually uh supports this, that he says diversification is a protection against ignorance. It makes little sense though, if you know what you are doing. And so he understands that yes, uh, lack of diversification is uh is riskier, uh, but if you know what you are doing, then it doesn't make sense to go out and just diversify in the name of diversification. And and so he does it, he he's also said that hey, for most investors, index funds are going to be the best way to go. That way you don't have to be that specialized investor, and that's what most people are, um, present company included. And but he said if you know what you're doing, then you can go and concentrate in this. And that's why uh Warren Buffett, Charlie Munger, and they talk about this circle of competence, these things that they are specialized in, what they know, in order to put a lot of those eggs in that basket where they have that circle of competence. And so in my mind, I'm going, okay, this is really good. I can make sense of that, diversify when you're uncertain, and then when you're specialized in something, you can concentrate your portfolio in that area. But here's one big rum. How the hell do you know if you are actually specialized in something? And what kind of things can you do to test this? And that's where we're gonna unpack the problem here. We are terrible judges of our own abilities and our own competencies. So before we start sorting this out, do we have an accurate gauge on our own competencies? And what we find here is first, there's overconfidence, this inflated self of our own abilities. And this also leads us into what we know as this Dunning Kruger effect. I mean, so I'm gonna walk you through the four stages of the Dunn-Kruger effect, and then we'll tie this together into a better system on how we can actually accurately gauge our own competency and the competency of others. And so they have four stages, um, this widely known Dunning-Kruger effect, and how we know when we've earned the right towards competency. Once you pass these four steps. Step one, this is called unconscious incompetency. And this is right when you just get started learning about a topic. Um, those of us who just got into finance, if you can remember this, first year of learning, there's so much to learn. Uh, but then you feel like, man, I I know it all now. And wow, this is so good. And this is the first phase where your confidence is actually the highest. Because you don't even know what you don't know at that point. You are just excited, you're learning, you go, oh, I'm a master at this. Uh, add in maybe a little bit of uh good experiences. So if you have your first trade that you make in stocks, you suddenly know everything about stocks and you can't miss. You know all the hot trends, and you've had one or two good trades, and your confidence is through the roof. It's what I see in a lot of early investors as well, and it has tends to get amplified by a couple of lucky punches in the first couple of trades, and that really, really amplifies it. But what we know is at some point, very soon, usually sooner before later, you're gonna enter into phase two, which is conscious incompetence. So now you're starting to be aware of the things that you didn't know, and you're realizing, oh wow, this is very humbling. I have a very long way to go. And so this second stage takes you from the highest confidence level out of all four stages down to the lowest confident level, the confidence level of all four stages. And this is usually when you start eating humble pie. Sometimes if you are overly leveraged, you can lose your shirt in this area. Um, but if you are able to dust yourself off, pick up the pieces um of your of your confidence and still explore this topic. This is where a lot of people quit. But if you're willing to keep going, you can move into stage three. And this is where you have conscious competence, where you start realizing pulling these pieces together, you've you've seen some good, you've seen some bad in the topic, you've had some good trades, bad experiences, but now you're starting to gain a little bit more competency, um, and you're actually now conscious about it, where your skills are now increasing, their actual competency, um, but you're still on the humility train, still trying to work your way back up uh in that topic. And then at stage four is when you have this unconscious competency where you're competent, you know it, but you still don't portray or still pretend that you know everything about this topic, but you have high confidence and it's still and now it's ground in actually being good at something. Yeah. So this is where you find the the four stages. If you can get to that fourth stage, then you can maybe think about that concentration in portfolio in that particular area. And so the way how do we know what stage we're in? Because if you ask somebody in stage one, what stage are you in? That's like, I know it all. I'm in stage four. So this is where we say, okay, tactically, to get to stage four, uh, we need some things in place. First, do you have a feedback system where you can get feedback from others on your competency, how you're doing? Uh, and then also, do you have some sort of time? What what sort of timetable do you have? Have you been doing this for three months, or have you been doing this for 10 to 30 years? Like that's a big, big difference on how you can gauge where you're at. And I mean, I can remember this and I hope, I hope I'm at that stage four in my professional life, and hope hope you're enjoying uh learning about this as much as I enjoy teaching this. Uh, but at the same time, I realized that in these stages, from being that that trader at Fidelity when I started in my 20s to really feeling like I knew it all, and then, and then, of course, getting humbled and and having to go through the financial crisis with a lot of my first investments, learning that the hard way, trying to pick up the pieces from there, and then moving into, you know, getting a PhD in in finance and and doing all of the academic review or the publications and and all the research and and then bringing that to light in the into like practical applications for people. That process to now get to that point of of going, and I really have a lot to share. I hope it helps people, and I hope it helps people who help people. Um, that's where the real impact happens. But I also understand that I also used to think that having a doctor it meant that I had to know everything about everything within finance. And I can't, I would be an imposter if I didn't know that and finally can get to that place of look, I I don't know everything. I'm still learning. And even in the area of behavioral finance, there's still many pockets of of learning that I can improve on. And so I like that, but that sort of narrative tells me that, all right, I think you're on this right path of being able to specialize in this, right? So anyway, um hopefully we can have a big enough business in this area where I say, yeah, I got to concentrate all my portfolio into this awesome business. And uh hopefully you can help me with that if you liked what you heard today. Uh would love to hear from you, first of all. Uh ask any questions, any feedback. We'd love to hear from you. Any topic ideas, also wide open to that. You want to be a guest, we'd love to hear from you about that as well. You want me to be a guest? Bring it on. You want me to teach in your class somewhere? Bring it on. Regardless, would love to hear from you. So please reach out. I'll have some contact information in the show notes. And with that, we will leave it alone and move on to the next topic next week. I look forward to seeing you there. Thanks everybody. Have a great day. We'll see you later.

SPEAKER_00 16:07

Thank you for tuning in to another episode of the Brian Fultis Behavioral Finance Podcast. We hope you found our exploration into the fascinating world of human behavior and finance, both enlightening and thought provoking. Be sure to subscribe for future episodes. And until next time, stay curious and financially savvy.