Warren Buffett once said, “Diversification is protection against ignorance.”
When you think about it, this quote makes perfect sense. If you diversify too much, you will never be an expert in any one industry or company and could lose sight of how to best manage your investment.
In this instance, ignorance is most certainly not bliss.
When trying to figure out how to diversify your portfolio, allowing yourself the time and patience to research and focus your attention on one company at a time will reward you with a remarkable payoff. No question about it.
Though our diversification strategy goes against the grain, I promise it will lead you down the path to success. This isn’t to say that diversification is bad. It’s not, especially if you use my recommendations to diversify your portfolio the Rule #1 way.
What Is Diversification?
Diversification is a management strategy that combines different investments in a single portfolio. In layman’s terms, this means that as an investor, you have interests in a variety of different companies, regardless of industry or product.
The purpose of diversification is to yield a higher return on a variety of investments, which will also ensure that you face a lower investment risk at the end of the day.
Sounds promising, right? Before you throw all your cards behind a diversification plan, though, there are a couple of things you need to know about how to make the most out of your investments.
A lot of people looking to diversify their portfolio put their money in mutual funds or bonds. Unfortunately, this gives them less opportunity to achieve breakout wealth creation through this type of diversification.
The only guarantee with this strategy is the certainty that you will have a mediocre rate of return if things are going well, and see a significant decline—though not as much as a stock decline—if the market dips.
However, Rule #1 abides by a different diversification philosophy. I do want you to diversify your portfolio…just not in the same way,your financial advisors may be telling you to.
Why Diversification Drives Fear for Many
Now that we’ve covered the true definition of what diversification is, let’s get into the nitty-gritty.
Many investors who want to diversify their portfolio tells us two things:
- They don’t research where their money is going, so they spread their funds thin.
- They are fearful of the market and have a lack of confidence in their investments.
You shouldn’t be worried about these, though, because as a Rule #1 investor, you’ve already done the research to find wonderful companies and you are certain in the investments you choose.
Think of it like this:
Imagine that your entire investing career had to be reflected on a punch card and you only get 20 punches for each investment. With this in mind, chances are you’d be more likely to take your time and make sure you’re not wasting precious punches on companies that are not worth it.
So when we talk about diversification, it is okay to diversify your portfolio. But, you want to be 100% sure of the companies you choose to invest in so you know you will be okay when the market drops.
Remember, during your research, you will calculate the margin of safety prices to help you predict when the market fluctuates. This removes fear from the equation entirely, allowing you to release emotional control over what lies ahead.
Is It Important to Diversify Your Portfolio?
Generally speaking, it is important to diversify your portfolio. We never know what the market will do, and you want to have a variety of options at your disposal no matter what happens.
For this reason, we never recommend putting all your eggs in one basket.
However, it is okay to select a few really good baskets that you are confident will double your money down the road.
This process is not really about diversifying at all. It’s about investing in your values, knowledge base, and ideas that you believe to be worthwhile.
How to Diversify Your Portfolio Using The Rule #1 Method
We’ve already touched on one of the most important principles of how to diversify your portfolio the Rule #1 way.
It is simple and straightforward: you need to invest in what you know.
Knowing the true value of a company along with any issues, changes, or trends within a certain industry will surely put you on the path to success.
In order to fully understand the in’s and out’s of any business, you need to invest time into your research.
I recommend starting small once you make the decision to diversify. You don’t need to be thinking in terms of dozens of companies. You only need to start with a select few companies to begin building a diversified portfolio.
Instead of thinking you need to diversify up to 200 stocks, choose 5-10 companies that you know have great value and will get you a higher return. In fact, some of the best stock portfolios are small. Warren Buffet’s portfolio only includes between 5-6 companies in total!
Think back to having that punchcard. The smaller your portfolio, the better. Be selective and confident in a few investments before you diversify stocks through expansion.
Now, here are some steps for us Rulers to consider when diversifying our portfolios. Check them out.
Step 1: Determine What You Know
Learning how to create an investment plan is critical in order to help you meet your long-term financial goals, and this begins and ends with what you know.
There are three circles that should always be taken into consideration before determining whether or not to invest. These circles focus on:
- What you spend money on
- What you value
- What your passions are
The idea behind this strategy is that you can reduce your investment risk since you already have the foundational knowledge about your specific areas of interest.
For example, if you spend money on marketing automation tools, value their efficiency, and are passionate about marketing technology, it might make sense to invest in companies like Hubspot, Marketo, or Pardot.
If you are more involved in the healthcare field, though, it would make more sense to put your money toward investments in that industry instead.
At the end of the day, go with what you know. In this case, familiarity breeds opportunity.
Step 2: Research Your Businesses and Their Industries
One of the most tried and true strategies in the investing world today is value investing— where you invest in individual stocks in companies that are priced well below their value.
To be sure you aren’t randomly picking your stocks, you’ll want to spend a thorough amount of time gaining a deep understanding of the companies you are interested in investing in.
This can include everything from their fundamentals, operational procedures, management, financial metrics, industry information, and much more.
Try to absorb as much as you can in order to make a great decision before you diversify stocks. The more information you have, the better results you’ll get.
Step 3: Buy Stocks on Sale
Who doesn’t love a sale?
If the option presents itself, you always want to buy a company at half the price. Knowing how and when to invest in stocks, will provide you with specific opportunities for coming out on top when it comes time to sell.
To reduce your risk of volatility, buy stocks on sale because the investment has nowhere to go but up. Theoretically, even if it were to drop, the market will eventually equalize and its value will return with time—and that’s when patience comes in handy.
However, over-diversifying can complicate things.
If the market is down, this can create issues since it will be more difficult to understand how your investments will turn out and you could just break even. In this scenario, it would be wise to exercise caution.
Step 4: Let Stock Diversification Happen Naturally
The good news is once you find—and invest in—companies at half price, stock diversification will happen naturally.
As time progresses, you will not need to keep accumulating a stake in numerous companies for the simple fact that they go on sale. At this stage in the game, it is simply best to regularly manage and monitor your portfolio patiently.
When the time comes to diversify, see what other industries are impacted by the ones you favor, let the process take its natural course from there. It shouldn’t be overwhelming. Taking the first step and getting your feet wet is all it takes.
Choose the Right Stocks for Your Portfolio
When building a diversified portfolio, it can be tempting to observe and follow in the footsteps of other investors that claim traditional methods are best.
Don’t follow the industry. Follow your intuition. Do your research, get intimate with the companies you’re interested in, and watch the magic unfold.
Learn more about what it means to diversify your portfolio and how to successfully begin investing in 2021.
Find out how to pick the right stocks for your portfolio with my 5-step checklist.
And if you’re searching for more general information, check out my The Ultimate Guide to Investing. In it, you’ll find everything you need to make great investments by minimizing risks and maximizing returns.
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.