Does diversification reduce risk? My answer: **no**.

Diversification in practice is a strategy designed to protect people from not knowing. Because if you don't know, you buy a little bit of everything.

Imagine you lived in a small town with ten banks. Would you split your money equally across all ten? Probably not. Common sense would suggest that some banks are better than others—this one has an excellent reputation, that one might not be the best. Even in a simplified world, we naturally discriminate.

Once you reach that conclusion, you realize that simply buying everything is an admission of not knowing anything. That could be perfectly fine, so long as it's done consciously and with proper rebalancing. But when panic strikes and one realizes one doesn't actually know what one owns—that's when you get poor investment behavior. Selling at the lows. Buying at the highs. As they say, the higher it goes, the cheaper it looks.

## The S&P 500 Illusion

The S&P 500 has become so prominent that it's viewed by investors as a sort of safe haven. Volatility is smoothed out by numbers. It's been rebranded in the collective mind not as a portfolio of businesses, but as something closer to a money market account.

This is simply not true. The S&P 500 is not a safety net. It's a crowd of businesses moving in different directions, all under the same label. You don't see that right away. You make the mistake of thinking the path will simply continue. And when it doesn't, you're surprised.

At some point, the rational investor starts to ask simple questions: Are all 500 companies equally promising over the next several years? Are the top 100 equally durable? Under what conditions will they do well? Will I want to own all of these for the next twenty years?

When you start asking these questions, you might identify a company that's terribly overvalued, deeply indebted, perhaps on the verge of bankruptcy—and it's in the S&P 500. In that one moment where any person familiar with business can see this clearly, you think: I'd rather not invest in it.

**And just like that, the S&P 500 becomes the S&P 499.**

That is the moment you open the door to realizing that not all companies are the same. Once that realization is in your blood, you understand the dangers of owning a little bit of everything.

## Expertise as Risk Management

Some things are better than others. And if you're going to own something, make sure you understand it well so that when you're tested, you do the right thing.

What is the test? It's always the same. Understanding the business like an operator—so that when there's an operational issue, you can make sense of it. Understanding it so well that when there's price volatility, you can discern whether that reflects the underlying business or simply a short-term market noise.

Getting to that level of expertise is hard. It takes time, focus, and passion. And that's what we do.

We can't apply this to that many companies because there's only so much time and so much expertise. Being an expert in what you own is, to us, fundamental. It allows us to buy the things that are the best and avoid the things we either don't understand or that have attributes suggesting they're risky.

We would rather not buy everything. At the very least, any investor with common sense should realize that simply removing some of the stupid things is a good idea.

Once you start thinking in that manner, active management starts to make a lot more sense.