Investing Concepts 101: Baskets, Eggs, and Diversification
The term Diversification is frequently bandied about by the financial media as well as by both successful and unsuccessful investors. In this post, I’m going to try and explain exactly what the term means, and exactly how this concept can be applied towards investing in web properties.
Diversification is one of those things that is easy in theory and difficult in practice. The idea is simple – basically, you shouldn’t have all your eggs in one basket. When you hear people talking about diversification, most of the time they’ll be talking about stocks – the idea in this case is that you should own a portfolio of many stocks rather than just shares in one or two companies.
This approach is fine when you want to be a passive investor – in fact,many of the great investors (including Buffett) agree that if you’re not actively involved in your investing, you’re best bet is to just buy a mutual fund/ETF that tracks the whole market (ensuring extremely high diversification) and just leave it alone.
This is actually a pretty good strategy if you’re someone who doesn’t really have much time to do proper research and due diligence into your investments. If you’re interested in this more passive, hands-off approach, read the Bogleheads’ Guide to Investing. This book outlines the kind of highly diversified, entirely passive investment strategy that I discussed – and if you follow the advice of the book, you will almost definitely do better than the average non-professional investor.
On the other hand, I think it’s safe to assume that if you’re reading this blog and this post, you’re interested in being more active with your investments. The problem with diversification when it comes to active investing is that it dilutes your best ideas.
Here’s an example as it applies to stocks:
You’ve done loads of research on Company A, and you know the business inside and out. You believe Company A has great prospects. However, you want to be diversified, so instead of just buying stock in Company A, you also buy stock in company B, even though you know relatively little about the company B.
So your best investing idea, that you’re 95% sure about, is diluted about the other investment you make, which you’re not sure about at all.
Now, that’s not to say that I don’t believe in diversification at all. As an investor, you’re going to be wrong sometimes, and you need to acknowledge that fact and build in some margin for error in your own judgment. What you don’t want to do is diversify to the point where you’re adding new investments that you haven’t properly vetted – just for the sake of being ‘diversified’.
Diversification & Website Investing
So, how does this apply to investing in websites? In my eyes, a discussion of diversification is even more pertinent when it comes to web properties. This is because a) Web Properties riskier in general than other investments and b) Web Properties require more ‘upkeep’ than most other investments (perhaps with the exception of Real Estate).
If you’re looking to invest in web properties, I highly recommend that you diversify, and at the same time I strongly discourage you from over -diversifying.
Say you have $20K worth of capital allocated for investing in websites.
You don’t want to spend that $20K all on one site, no matter how thoroughly you’ve researched it. There are myriad ways that a website investment can be damaged – technical difficulties, a change in a trends, the dreaded boot of Google stomping your website downwards in the SERPs – all these things can theoretically happen at any time. Good due diligence can reduce the risk of these events occurring, but it cannot remove the risk entirely.
On the other hand, your level of diversification is limited by how much time you have – both for research and for website maintenance, upkeep, and improvement. If you only have 20 free hours in a month, and each website on average needs 4 hours a month of maintenance, then you don’t want to be managing a portfolio of 20 websites. You won’t be able to keep up and your website investments will suffer accordingly.
In a similar vein, if researching one website takes you 10 hours, and you have 20 free hours a month, you shouldn’t be buying 4 websites in the span of that month just for diversification purposes. It takes time to do proper research, and it’s almost always better to have 2 really good, thoroughly researched, well though out investment ideas rather than 4 half-baked, poorly researched ones.
Diversify enough to adequately protect yourself against lapses in your own judgment and uncontrollable risks from external sources (Google, hackers, technical issues, etc). Do not diversify so much that the quality of your research and due diligence declines.
Back to baskets and eggs
I’ll come full circle here – I’m going to bring it back to the eggs/basket analogy.
It’s true that you don’t want to put all your eggs in one basket. On the other hand, if you check that the baskets are well made, you should be quite confident carrying your eggs around in 4 or 5 well crafted, high quality baskets.
You definitely don’t want to use a bunch of baskets that haven’t been checked – if the craftsmanship is shoddy and the baskets are of poor quality, who knows what will happen to your eggs. You’d rather have a few high quality baskets that you’ve checked, rather than many baskets which you’re unsure of.
To finish off, I’m going to quote the great Warren Buffett.
“Diversification is protection against ignorance – it makes little sense for those who know what they’re doing.”
We can’t always be 100% sure about what we’re doing – that’s why a little bit of diversification makes sense. But diversifying too much is admitting that you’re ignorant about what you’re investing in – and if that’s the case, you probably shouldn’t be investing in websites at all.