Brian Lund: We're here to discuss diversification.

Focused investing
We pick only a select few stocks for our portfolio. We believe that we can choose our stocks out of the entire pool of stocks on the market and still manage to beat the market averages. Each stock we buy will probably differ greatly from the average return of the whole pool, which is what an index fund would return. So, how sure are we about our stock selections? In relation to that, how much of one's savings should go into individual stocks?

David Gardner: Well, we believe that every investor should start with the index fund. "Investor" here is defined by someone who's investing money they won't need for at least five years.

We believe, however, that everyone in America should own one stock! Your first individual stock investment should probably represent not more than 5%-10% of your savings, but everyone should own one to start with -- just to dip your toe in the water. If you find yourself enjoying the process, continue to add to individual stock holdings. If you don't, or aren't doing well, back off to the index fund again.

That's my context for beginning to understand "diversification." Your percentage in individual stocks vs. an S&P 500 index fund is a function of how enthusiastic, confident, dedicated, and non-risk-averse you are.

Brian: So, we think people should start with index funds. We'd like them to own a stock, to have a sense of enfranchisement. Is there a point, do you all think -- a percentage of money invested -- at which you don't want to take the risk of individual stocks? Should a certain percentage of your wealth be reserved for index funds?

Paul Commins: That point should vary from person to person, based on how well they believe they can pick stocks over the target timeframe, and on their ability to shoulder losses without putting their basic financial plan for the future at risk.

Jeff Fischer: I agree that it should vary, but I disagree with allotting specific percentages as a rule, namely because the percentages will be changing all the time, as positions rise and fall. As you start, perhaps you logically divide your money with each new buy. But over time, typically, you should let your positions develop as they will -- it's the old "let your winners run" mantra.

Paul: Isn't the strategy, as we teach it, more of a stock-picking strategy than a portfolio-management strategy? I guess that's where a lot of people get confused.

David: Yes, we are teaching a stock-picking strategy foremost. People who look to our portfolio as a model of how to build a portfolio have missed all our teaching in the Fool's School, our broader writings online, our speaking publicly, etc. Again, for some people, sticking to a single strategy may be best, but for most we advocate a majority in index funds and a sliding percentage of your long-term monies in individual stocks depending on your enthusiasm, time, risk tolerance, intellectual curiosity, etc.

Why not buy a basket of potential Rule Breakers?
Brian: Perhaps we should segue into diversification in the context of the Rule Breaker Portfolio. I think this may be the more contentious part, and our readers want to see some blood.

Why don't we diversify across more Rule Breakers? We have three biotech stocks, three Internet stocks, and a coffeehouse. If ours is a "swing-for-the-fence" method, wouldn't it be better to take more swings (i.e., buy many more stocks)?

Jeff: Brian, let me expound. Three Internet stocks: AOL Time Warner (NYSE: AOL), a multimedia giant, the largest in the world; eBay (Nasdaq: EBAY), a worldwide trading platform; and (Nasdaq: AMZN), a worldwide retail channel. These companies are not all in the same industry, although they use the same technology.

Paul: I answer Brian's question this way: We should only take as many swings as there are bona fide Rule Breaker stocks to buy and time to find them. Otherwise, we're back to picking blindly from the stock pool.

Brian: Are we really saying that we see only seven Rule Breakers in the world, and that three of them are biotechs?

Paul: Got another one?

Jeff: I believe that we do take many, many swings -- in our research. Every time we set out to research a company, committing time and effort, we're taking a swing. Ninety-five percent or more of our research ends without a buy. What you see in the portfolio, hopefully, are our few swings and hits. So, we should take many swings publicly (that is, share our research, as we have done most recently with our Break Down August). But I believe our method is to be very meticulous in the research to limit the number of times that we actually connect with a buy... and hopefully, then, a majority of those buys will be successful.

Paul: Indeed. Less is more. We should always lean very strongly toward not buying anything, I say.

Brian: Some investors would argue that it's better to buy a basket of leaders. For example, how sure can we really be that Human Genome Sciences (Nasdaq: HGSI) will prove to be a better investment than Millennium Pharmaceuticals (Nasdaq: MLNM)?

Jeff: Buying baskets is a different strategy from ours, and one that will work in some cases. Buying baskets of stocks goes against one of our Rule Breaker criteria, though: We want to buy only the top dog and first-mover with gusto. HGS and Millennium are good examples of a case where we could have divided the money and bought both in equal amounts, given how young and uncertain but promising both are. We considered that possibility at the time. But buying baskets just to buy baskets will result in having, usually, very many losers -- more losers than winners.

Paul: Here's why I don't like the "basket" approach. In emerging industries, everybody is excited about everybody. Because nobody really knows much about anybody, there's more buzz than fact. Early on, most players are hugely overvalued. In other words, the total industry is priced higher than it can ever deliver, due to the buzz and the lack of info.

Once the pretenders collapse, however, the emerging Rule Breaker suddenly looks undervalued in hindsight, as it soaks up the value freed by all the disappointments. If we buy the basket, I think we pay too much for the industry. Anybody can pick a hot industry, it seems to me, and overpay for the basket.

If we don't think we can pick a winner, we should just stick with the index fund.

Jeff: Business-to-business (B2B) was the perfect example. Everyone was excited about every company, for a while. The challenge, as Rule Breaker investors, was to spot the tog dog. If we can't, as we didn't, then we don't invest.

David: I think you can spot the "real leader" in many cases pretty early on without having to buy the industry -- e.g.,, not Amazon/ (Nasdaq: BNBN)/Borders Group (NYSE: BGP)/CDNow, etc.

Why not buy the leader in every emerging industry?
Brian: Well then, if we don't want to diversify within an industry, is there any benefit in spreading out into more industries? If B2B is emerging and important, why don't we own its top dog?

David: I have a hard time investing my money in something that I don't have a direct consumer connection with, which is part of the reason that "strong consumer appeal" is one of our business criteria.

I don't feel that I have to own every industry, only the ones I can understand. B2B just hasn't been a personal interest fitting in with my hobby, experience, savvy, etc. (fulfilling the Foolish axiom "Buy what you know"). We had a sense that maybe we "had to own that," but we lacked enough real savvy to get us to the purchasing table. Which again is OK... we can't know everything.

Overweighted in one stock
Brian: All right, let's explore another area of diversification. We've got more than 40% of our money in AOL Time Warner. How does this affect us? We've rebalanced before, selling off pieces of AOL, Iomega (NYSE: IOM), and Amazon when they became a large percentage of the portfolio. At what point do we consider doing that again?

Jeff: We'll sell a portion of our largest holdings to buy something new. We'll do that once we've found something better. In the past, we have used proceeds from AOL, Amazon, and Iomega to buy new positions, and we'll continue to do so. But here's another thought related to the weight of AOL in our portfolio: The company isn't growing as quickly as it used to, so the stock will not appreciate nearly as quickly. Over time, AOL Time Warner will probably become a smaller part of the portfolio again. To go out and purposely make it such, though, is counter to Foolishness.

Brian: Is it?

David: I have an open mind, and would part with AOL should we "find a better place," as we've said in the past.

Brian: We've said, in various places, that rebalancing is Foolish.

Jeff: I think it can be. Something forced, though, is unFoolish. Forcing ourselves to sell AOL shares just for the sake of an ever-changing percentage would go against the "sell when you find something better" belief. Selling AOL in the past ('97, '98) when it was 50% of the portfolio, just to balance ourselves, would have been costly. AOL soared in those few years and has held those levels since.

Paul: Isn't the goal to hold potential Rule Makers for a lifetime? Even if they no longer have Rule Breaker growth potential?

David: Yes and yes, to both Paul and Jeff.

Paul: In other words, how do we define "something better"? A Maker could never beat a Breaker on the Breaker scale?

Brian: Don't y'all think that there are higher-growth possibilities out there?

David: You have to balance new possibilities against what you perceive to be, say, the market performance for existing invested monies on which you'd be paying capital gains taxes, and also recognize that those invested monies are lower risk -- significantly lower, since you got them invested in something that grew to be a tall oak. So, invested money carries with it a higher opportunity cost of switching than uninvested monies.

Brian: True, but are we interested in low-risk investing?

Jeff: We're interested in a balance, I think. We want our Breakers to become Makers, and we'll typically want to hold the Makers when we've got them. The Fool has an entire portfolio that only holds Makers, after all.

David: We have, several times in the past, sold some of that great oak to fund the planting of acorns. So, that's not an issue. We do consciously take on significant risks with each investment and with the monies already invested. Yes, it is about risk, in the end, because it's all about risk, underneath -- balancing what you perceive to be risk against reward.