Rule #1 Finance Blog

With Investor Phil Town

Is There Anything Wrong With Diversification?

Are there benefits of diversification? What if you split up your capital across 3-5 different companies in different industries? Not talking about a basket of 20 stocks, but doesn’t some diversification make sense?

You can do everything right and still have an unforeseen event sink your battleship. Like a natural disaster that wipes out your company. Or a misinformed short selling attack out of nowhere that may be totally false but can wipe out half your investment.

You may have some of these same questions when it comes to stock diversification, so let me answer them for you.

Is Diversification Overrated?

The short answer is that diversification, in general, is overrated, but 3-5 businesses hardly counts as diversification by the standards of the financial services industry.

If you are managing someone else’s money and are not a genius and do not want to be criticized by their accountant, you’ll spread their money across cash, bonds, real estate, commodities, and stocks and call yourself a pro.

And you’ll also have about a snowball’s chance of producing a significant return on invested capital.

If you are managing your own money and want to be and stay rich, I’d recommend doing what the best investors in the world do: Learn how to invest Rule #1 style.

How to Diversify Your Portfolio

Diversification is simple: Focus your portfolio on businesses you understand, that you know you are buying cheap, and let the diversification happen naturally.

It is worse to be in things you don’t understand than to be un-diversified in industries you do understand.  If you’re doing your work well, you shouldn’t have an industry-wide permanent bad surprise.

The number of stocks I own, and thus my diversification, such as it is, will ebb and flow as I find great businesses to buy.

Sometimes I have 10 stocks…

Sometimes none.

I buy real estate like I buy businesses. Same Rule #1 rules.

Commodities like Gold? I hedge by trading like I showed you in my first book, Rule #1.

The Best Way to Invest $1,000 vs. $100,000

The amount you’re investing matters, too.  With $1,000 you can buy one stock.  Trading friction will eat up your return otherwise.

With $100,000 you can do 5 to 10 if you can stay on top of that many.  Lou Simpson, who ran Geico’s $2 billion fund, had an average of 8 stocks.

For Rule #1 investors, diversification is a by-product of finding companies to buy.

Company A is cheap, I buy it. It goes up and it’s not cheap anymore so I’m done buying, but I still have money to invest.  I find Company B and buy it.  It goes up and it’s not cheap anymore so I’m done buying, but I still have more money to invest… And so it goes.

I’d argue that diversification is not a free lunch at all. I think it costs quite a lot in time and education to be able to successfully buy businesses in many industries and across asset groups.

Invest in Companies You Understand

Let diversification happen naturally.

I think it’s a better, safer investment strategy to buy one right thing over and over again, rather than many wrong things once.

Novice investors who are concerned about losing money on their first investment should not invest more than they can afford to lose.

Or, even better, they shouldn’t invest at all.  Just paper trade until their confidence goes up to a point where they sleep well at night knowing they bought a great company.

Getting to a place where you are comfortable takes time.

If you are investing a million dollars that you can’t afford to lose, you might take a few years to get to a place where you are comfortable with that responsibility.  Until then, either sit in cash or diversify by buying market wide ETFs, like SPY, or trade carefully and gradually add great businesses that you know you understand.

To learn more about Rule #1, click the button below to get my Quick Start Guide to Rule #1.

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Phil Town is an investment advisor, hedge fund manager, 3x NY Times best-selling author, ex-Grand Canyon river guide and a 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. You can follow him on google+, facebook, and twitter.