Photo: Fortune Live Media via Flickr.
"Wide diversification is only required when investors do not understand what they are doing."
--Warren Buffett
We would be ill-advised to ignore any investment guidance from Warren Buffett, so let's explore why one of the best investors ever would be against diversification. There's a good case to be made against it, but you might do well to diversify anyway.
Diversification drawbacks
A chief knock against diversification is that it diminishes the power of the holdings in your portfolio. A simplified example will make this clear: Imagine a $100,000 portfolio with $10,000 invested in 10 different stocks. If nine of them stay put but one doubles in value, the portfolio will be worth $110,000. The doubling stock has a 10% influence on the whole portfolio. Now imagine a $100,000 portfolio with $1,000 invested in each of 100 different stocks. If 99 don't change in value but one doubles, the portfolio will be worth $101,000, with the doubling stock moving the portfolio's needle by just 1%. Of course, keep in mind that this diversification also reduces the negative impact of holdings that plunge in value; that's one way in which diversification is helpful.
Another drawback to diversifying is that it can make it hard to keep up with your holdings. If you like to invest in individual stocks that you've studied and selected on your own, for example, you'll need to follow them and keep up with their progress -- ideally at least once a quarter, when they release their latest financial reports. As the number of holdings you maintain grows, that becomes harder to do. With a dozen companies, if you spend an hour per quarter on each, that's 48 hours per year -- not an insignificant sum of time. If you hold 50 companies, you'd need 200 hours to be as diligent.
Another diversification drawback is that it can allow us to be lazy. If you're determined to own only, say, 10 stocks, you'll probably work hard to make sure you own the 10 most promising stocks around. But if you're less selective, you may end up investing in your 57th-best idea, too.
In his 1993 letter to shareholders, Buffett came down against diversification for some, explaining: "If you are a know-something investor, able to understand business economics and to find five to 10 sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk."
Why diversify?
It should be clear by now why most of us should embrace diversification, despite Buffett's warnings: Most of us are not expert investors with a deep understanding of one or more industries. Few of us can match Buffett's discipline, patience, and respect for the limits of his knowledge -- traits that make him one of the worlds best investors.
As Buffett added in that 1993 letter:
Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know- nothing investor can actually out-perform most investment professionals.
How to diversify
Both Buffett and your friends at The Motley Fool have long advocated the same simple way to diversify -- through inexpensive, broad-market index funds. Vanguard pioneered index funds and offers a wide array of them today, but now many firms offer them. Opt for ones with low fees ("expense ratios"), as some have fees so low that the companies are practically managing your money for nothing. Exchange-traded funds (ETFs) are stock-like funds that make index investing extra easy. The SPDR S&P 500 ETF (SPY -0.49%) will instantly plunk you into the S&P 500 stocks, while the Vanguard Total Stock Market ETF (VTI -0.54%) is even broader, including small-cap U.S. companies.
It's smart to diversify your portfolio not only by quantity of stocks and range of industries, but also by geography. The Vanguard Total World Stock ETF (VT -0.32%) gives you most of the world's stocks and only charges 0.18% of your assets per year.
If you don't have a lot of time or investment skill, diversify your portfolio via one or more index funds. They can give you entire markets for just a few dollars a year. And you'll have Warren Buffett's blessing, too.
