A popular mantra in the world of investment advising is the idea of diversification, of dividing your money into several different types of investments instead of just one or a few and, in the case of stocks, into several different companies.
This is in stark contrast with Warren Buffett, considered one of the most successful investors of all time and arguably the most famous, who once said:
Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.
So whose opinion does an investor take into account: that of the widely accepted consensus of the investment advising community or that of none other than the “Oracle of Omaha”?
To Diversify or Not?
It might help to break down the idea of diversification a little more than what was stated above, namely, considering the different types of investments and also the number of investments.
Regarding types of investments, the investment advising community largely recommends that one put their money into mutual funds and ETFs. A mutual fund or ETF is essentially a “basket” containing many “eggs”, or different types of investments or “investment vehicles” like stocks, bonds, cash, etc. (If you don’t know the differences between mutual funds and ETFs, here’s one resource.)
Without getting into a description of the different investment types/vehicles (instead of me re-inventing the wheel, you’ll need to do some homework), suffice it to say that the argument in the investment advising community is that having several different “eggs” (stocks, bonds, cash, etc.) in each “basket” (mutual fund or ETF) reduces the chance of risk. In other words, any misfortune or failure befalling one or a few of the “eggs” should not greatly affect the overall value of the “basket”. The investment advising community encourages one to diversify further by investing in not just one mutual fund and/or ETF but several.
I find it interesting how Mr. Buffett’s quote shown above derides the idea of diversification when the holdings of his Berkshire Hathaway are numerous and cut across many different industries. Here’s another link from the Berkshire Hathaway site itself. On this basis alone, Mr. Buffett has fully justified the idea of diversification and at the same time appears to have contradicted his quote, leading me to wonder about its context and at which point in his investing career he shared it?
To not come across as thinking I have this all figured out, however, here’s another take on Mr. Buffett’s quote that is a worthwhile read and seems to clarify what he truly meant. In short, it justifies diversification, but not to the point where losers cancel out winners to the point of minimal net return. To avoid this, a thoughtful, calculated approach is needed, not just randomly buying all sorts of stocks.
Find a Balance
With thoughtful, calculated diversification found to be a good idea, let’s think about a more important matter: how many investments should one own? Because this blog specializes in discussing stocks, since they are my area of greatest investing experience and success, I will discuss how many stocks that one should own. You can apply this number to mutual funds, ETFs, and bonds if you wish, but I’ll use the illustration of stocks.
In my travels around numerous free investing sites and also poring through the articles of subscription services, the typical number of recommended stocks that one should own is at least a dozen. More is better, but too many can cause investors to become bogged down, causing them to potentially miss out on news that can be crippling to a particular stock long term and thereby miss a chance to sell before a large drop in price occurs.
I read an article one time that suggested owning stocks in 30 companies was the perfect number, as statistically this most closely mimics the performance of major stock indices like the S&P 500 without an investor getting too overwhelmed by keeping up with news about each company.
To summarize, diversification is definitely good, but there has to be a balance in terms of the number of investments held.
The Dangers of Under-Diversification
I want discuss one final matter, namely the dangerous practice of some people not diversifying much or at all. I’ve personally known such people and, when I was a very ignorant and greedy investor, I did it myself for a time and paid dearly for it (and needed several years to make up for it).
This is typical of people working for the government, an institution, or a corporation where there’s a pension plan of some sort. It’s fine if that plan invests in a pension fund that has numerous investment holdings, but the most dangerous scenario is working for a company that gives eligible employees only shares in its company’s stock and nothing else. I was doing contract work at a company just this past year that offered this. Sure, it’s a great incentive to get employees to work harder and smarter in order to see the company’s share price rise, but external factors beyond that company’s control can cause the share price to dive and even for the company itself to fold, making the pension plan worthless. I tried to encourage people there to do their own investing in addition to having this stock-based pension plan, either through consulting an advisor or looking into self-directed investing. Unfortunately, most people are very short-sighted or nervous about having to do their own research; they’re often more than happy to let a company or investment advisor do all the work for them, entities that often don’t have their employees’ or clients’ best interests at heart.
For people who don’t have the benefit of a work pension plan, but who’ve wisely realized that getting only a government pension after age 65 simply won’t keep them above the poverty line, they often will buy, for example, a mutual fund or two, a bond, perhaps an ETF – some sort of minimal combination – and that’s usually it. Often, stocks are considered too risky and therefore scary and so they avoid them altogether. Some people hang their entire retirement hopes on only one of these investment vehicles! Again, I speak from past experience. As explained above, placing an egg or two in only one basket or two is putting your entire financial future at risk.
Your best bet over a long time frame has been statistically proven to be owning a number of different stocks across a number of different industries – and quality stocks at that, like the leading and/or most innovative companies in those industries. Information about such companies can be found in a lot of places, but I personally recommend starting with the fantastic resources found at The Motley Fool.
The Final Word
Diversification is not a fail-safe way to insure against experiencing loss. You have to research and understand what you want to invest in instead of blindly choosing a bunch of random investments across a swath of industries. You can learn a lot about how to do this from the likes of Mr. Buffett and The Motley Fool. In other words, sheer numbers won’t make up for ignorance. Without a thoughtful, calculated approach, you might even end up with a net effect of zero gain, with losses balancing out any gains or vice-versa, instead of building an understanding that causes you to pick more long-term winners than losers.
The bottom line is that diversification is indeed good in theory, but without building understanding about what you invest in, it might end up actually being of little or no benefit. Again, the article referenced above explains the importance of approaching diversification by building understanding instead of being merely passive about it.
One last thing: be sure to click the Follow button near the top of this page. Also, if you’re a brand-new stock investor – or still thinking about it – then I highly recommend starting with my 5-part Stock Starter Series. To new beginnings!