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Why Diversification is for the Ignorant

Phil Town
Phil Town

A word you will hear time and time again in the investing world is diversification. Diversification is the idea of creating a portfolio that includes multiple investments in order to reduce risk. Someone who is an entrepreneur might think it best to lower his risk and have 100 businesses, rather than focus on one or two. Most people over-diversify. The split their money into hundreds of stocks in hopes of making a great return. If you know how to invest, you don't have to diversify.

One of my favorite Warren Buffett quotes says, “Diversification is protection against ignorance.”

Most people will trust a financial advisor to spread their money across any and all investments they can find - from cash bonds to real estate commodities, or even hundreds of stock funds. All of that is considered by good investors to be massively over-diversified and unhelpful.

At best, you might break even with the markets that every one of those things are in. Naturally, as an investor, you are going to diversify a little bit, ending up with 5 to 10 companies. That’s just how it works. In order to generate consistent returns and make a lot of money, it’s smart to take the Rule #1 approach.

Go out and find businesses that you understand and believe in. Know the companies from the inside out, make sure they are being run by great managers, and buy them on sale.

Like I said, you may diversify your portfolio a bit, maybe 3 to 5 different businesses. I like to say 10 for people who are just getting started. Obviously, you won’t end up with them all at once unless the market crashes and puts everything on sale. Generally, you step in and put money in one at a time.

This will ensure that you are gradually building your portfolio with a small number of businesses that you really like.

Warren Buffett has about 70% of his money in only a handful of stocks according to this article.

According to the standard of the industry, this is not diversification. The standard is four different exchange-traded funds, each with 200 stocks in them.

Here are some more quick tips to help you once you start investing on your own:

1. Get Focused on One Area of the Market

I say it’s best to be an inch wide and a mile deep. Find companies that match your values, and wait patiently to buy them on sale. A couple years ago in 2008, a time when the market was down, Warren Buffett was asked, “Aren’t you upset the market is going down?” He replied, “No, I want to buy more as it goes down.”

When you know what you own and you know you have a good business, a down market is a wonderful time to invest.

However, a down market is a nightmare for diversified investments. You don’t know when the market will go back up and you can’t keep track of your investments.

2. Know the Value of the Business

Professionals tell you to diversify to protect yourself from risk.

Here’s the truth: Risk comes from not knowing the value of a business.

Imagine yourself driving your car to work. You know you’ll get to work safely, you’ve done this a million times. Now imagine driving the same route, in the same vehicle, except a 12-year-old is behind the wheel. You probably won’t make it into work today.

The journey and the vehicle for investing are the same. Education and knowledge about the business are the differentiators between good and bad investors.

3. Buy $10 for $5

Buying $10 for $5 is what we’re out to do as investors. The nature of the game is buying companies at half price. Do it when rare opportunities come along.

Buy the business and when it starts to go back up, you won’t buy anymore but instead look for another opportunity.

4. Let Diversification Happen Naturally

In 20 years, you might own a total of 20 companies as the result of natural diversification. The bottom line is this: buy a few businesses that you are knowledgeable about, ones that you can buy on sale, and learn how to invest with Rule #1.

Before we wrap up, have you ever had funds over-diversified with a professional? Were you getting the returns you hoped for? Leave a comment below and I’ll be sure to follow up with you!

Are you wondering if a certain business is a smart investment? Make your investment research simple with my FREE and easy to use 5-Step Checklist for Picking Stock! Ensure all of the investments meet Rule #1 requirements before you buy.

How to Pick Rule #1 Stocks

5 simple steps to find, evaluate, and invest in wonderful companies.