It’s fairly well known that in order to accomplish anything of significance it requires the focus of attention, energy and resources.

Yet somehow when it comes to investing, concentration seems to be a four-letter word.

Diversification gets all of the glory as THE way to invest and a key component of sound risk management.

Like a game of telephone that started in the '70s, the definition of “diversification” is now somewhat butchered. “Diversification” now means the more investments you have in your portfolio the better.

Is that really diversification?

The true definition of diversification is the concept of having a portfolio of UNCORRELATED positions. Positions that zig and zag from each other at different times.

You can accomplish this by investing in positions, long and short, whose prices are driven by different catalysts. The truth is, most investors abide by the more is better philosophy when it comes to investments in a portfolio. In fact, some of you reading this may be employing a similar philosophy when making investment decisions.

Hopefully, the commentary that follows will embolden you to rethink how you view “diversification.”

Who are the richest people in the US? Look at the most recent Forbes list of the 400 richest people. Specifically, look at the top 10. How did they acquire such vast wealth? No. 1 Bill Gates, 1 stock, Microsoft.  No. 2 Warren Buffett, 1 stock, Berkshire Hathaway.  No. 3 Larry Ellison, 1 stock, Oracle. Nos. 6-9 Walton Family, 1 stock, Walmart.  No. 10 Michael Bloomberg, 1 company, Bloomberg L.P. So, 8 out of the top 10 richest people in America accumulated their vast wealth through CONCENTRATION, not diversification.

But maybe you’re saying to yourself, “but these people risked a lot by being concentrated.” Let's dig into the reality of “diversifying” across multiple investments.

Let’s look at a brief example using 3 consumer discretionary stocks: Dick's (DKS), Nike (NKE), and Lululemon (LULU). If you run a correlation analysis evaluating those three stocks in a portfolio you get a correlation coefficient that ranges between .43 and .71.

This indicates that Dick's, Nike and Lululemon have a moderate to strong positive relationship. This means most of the time these stocks move up and down in lock-step. The most important aspect of this is that these stocks generally fall at the same time, eliminating any advantage to diversifying for the sake of risk management. 

Looking back at the last couple of years of price movement bears this out. These stocks have experienced a couple of significant declines over the last couple years. 

From May 4, 2012 through August 3, 2012, LULU declined 36%, NKE declined 20% and DKS declined 6%. So, just from this very superficial analysis there wouldn’t appear to be any additional safety gained from having all three companies in your portfolio versus risk managing with ALPINE and ABYSS lines the 1 stock you like the best.

This idea that diversification is some kind of Holy Grail of investing is not just limited to language arts teachers and individual stocks. Diversification is also the cornerstone of most financial advisors' investment plans for their clients.

I'm currently helping a family member evaluate the proposal of a financial advisor for an inheritance she recently received. The advisor recommended a portfolio of 12 different mutual funds, three of which were bond funds and the remaining 9 were various equity funds. The equity funds covered the large cap, global real estate and world allocation categories based on Morningstar’s ranking system. However, when I evaluated each fund, I discovered something interesting. 

Each of these funds, including the global real estate and world allocation funds had at least 70% of their assets invested in US companies.  Furthermore, at least 83% of these 9 funds' assets were invested in large cap companies.

Needless to say, it didn’t surprise me when I ran a correlation analysis on these funds and determined that they correlated to each other from a low of 0.79 to a high of 0.95, which means that the price movement of these funds very closely resembles each other. In addition, the correlation of these funds to the S&P 500 (SPY) ranged from a low of 0.88 up to a high of 0.96. In statistical terms, this means each of these nine funds essentially moves lock-step with the S&P 500. The fees on the funds ranged from 0.41% up to 0.97%.

That sounds pretty decent for actively managed funds until you factor in the fact that these are institutional shares of the funds which are going to be purchased through a wrap account that charges 1.5% per year of assets under management. That brings the total cost up to a minimum of 1.9% per year for 9 funds that have the exact price movement of the S&P 500 exchange traded fund that charges .09% per year.

The fixed income funds painted a similar picture. The correlation amongst the funds ranged from 0.49 to 0.72, this indicates a strong positive relationship.  These three funds also correlated to the iShares Core Total Aggregate US Bond index (AGG) from a low of 0.64 up to a high of 0.94.

So even though one of the fixed income funds was a “global bond fund,” the funds move lock-step, up and down with AGG.  The expenses of these funds versus AGG was also similar to the equity fund comparison with SPY. Bottom line: The advisor’s plan was to spread the inheritance out over 12 mutual funds and charge roughly 2% per year when a portfolio with very similar statistics (beta, standard deviation, and better 1,3 and 5 year performance) could have been constructed putting 70% of the inheritance in SPY and the remaining 30% in AGG for a per year cost of 8.8 basis points.

Not to mention, it's certainly easier to keep tabs on 2 investments rather than 12.

Evaluate your own portfolio including your 401k to see if you (or your advisor) are guilty of diversifying for diversification’s sake. There are plenty of resources online to help you determine the portfolio characteristics are of a basket of holdings. In my experience, there are very few circumstances where less is more.

I can understand that it might feel better to have 12 funds instead of 2. It might feel like the portfolio is safer the more your money is spread out. But when has feeling ever improved investment performance? 

The underlying reality is often times like the advisor’s proposal -- 9 different mutual funds all relying on just one trade, large cap US equities. Make sure that each of your holdings has a purpose and ideally, each holding is beholden to only one investment thesis or one driver of asset prices.

Remember what film and television actress Betty Buckley said, “Good performance is about the capacity to focus and concentrate.”