If you want to see differences between the Rule Maker portfolio and the way, for example, a typical mutual fund is managed, we've got a few measuring sticks.

We don't churn stocks in and out of the portfolio chasing hot streaks. In fact we haven't sold a single stock yet -- even though we're considering selling Gap (NYSE: GPS).

We also don't necessarily diversify. That's what I want to talk about here, since I spent the weekend reading Robert Hagstrom's excellent book, The Warren Buffett Portfolio, which argues in favor of a focused investment portfolio. It's very similar to the way we think about things in the Rule Maker.

What's a focused portfolio? Focus investors like Berkshire Hathaway's (NYSE: BRK.A) Warren Buffett, pick a handful of the best companies they can find and invest big sums for the long haul. That's pretty much all there is to it.

(I should mention one important difference between Buffett's methods and ours. Buffett is a very price-conscious investor. He won't invest in a company unless it's available at a significant discount to intrinsic value. We pay much more attention to quality than price in the Rule Maker; and this, in my opinion, adds risk to our strategy.)

How many companies should a focus investor own? The high-water mark is really 15. We hold 12 in the Rule Maker portfolio. This is strikingly different from most mutual funds. The typical U.S. equity mutual fund has 145 holdings, according to Chicago-based research firm Morningstar Inc.

Think about that. The average mutual fund owns nearly 150 stocks. Do you think the average mutual fund company has analysts who really know all 150, track them on a weekly or quarterly basis, and can quickly articulate how each company turns a profit? Do you think there are even 150 companies worth investing in, worldwide? I seriously doubt it.

Now consider that more than 80% of all equity mutual funds with a 10-year track record have underperformed the market average, while charging higher expense fees and loads than an index fund, and failing to take into account the impact of capital gains taxes on clients' portfolios. That's just plain shabby. If a waiter in a restaurant treated me that badly, I'd get up and leave.

Diversification is used as a hedge against risk. A diversified fund often has its assets deployed in a range of industries, a range of companies at different points along the growth curve, and in companies of varying size. If one holding steps off the beam, diversification mitigates its impact on the portfolio.

The best example of the strength of diversification is the S&P 500. It's averaged 11% annual returns for almost 80 years. If you're looking to participate in the market with minimum risk, there has historically been no better way -- over the long term -- than an index fund that mirrors the market.

If you want to beat the market -- no easy feat -- and you enjoy studying equities, then it's time to start thinking about a focus portfolio. Folks have preached diversification so long it's axiomatic, but we've taken a different tack in the Rule Maker. We pick the best companies we can find and limit the number of holdings. Why invest in lots of companies we don't know or understand when we can put more money in those we believe in?

Hagstrom defines the diversification problem clearly. It has to do with the definition of risk. Buffett defines risk differently than the typical mutual fund manager, and so do we. The typical mutual fund equates risk with price volatility, also called beta. Mutual funds seek to limit volatility in an effort to boost near-term results.

Here's how we define risk: The likelihood our companies won't continue increasing in value at a market-beating rate. It could happen. We think about it all the time, and that's why we run the numbers on a quarterly basis and continuously seek to better understand what advantages they possess.

Our definition, however, has nothing to do with price volatility. Therefore we're not interested in reducing volatility from quarter to quarter, or even year to year, since we don't measure risk that way. We don't care if the Rule Maker is volatile. What we care about is economic value. If our companies are increasing free cash flow year over year, increasing profits without leveraging the balance sheet, then we know the value and stock price will eventually converge and we'll be rewarded.

If we get pounded for losses one year, two years, or even more, yet believe the companies are among the world's best, we'll take our beating and continue holding. Personally, I don't expect the Rule Maker to beat the market every year. In fact, I expect it to lose, perhaps for an extended period. Overall, however, I expect to beat the market by a few percentage points, and for those gains to compound handsomely without the high costs of churn.

Consider this example regarding volatility from Hagstrom's book. The Sequoia fund, run by Bill Ruane, one of Buffett's classmates at Columbia, generated average annual returns of 19.6% from 1971 to 1997, beating the S&P 500 by 5.1 percentage points. Not bad work, eh? According to Hagstrom, the fund owned between six and 10 companies during that time, representing more than 90% of the portfolio. Sequoia is a focus portfolio (and its biggest holding is Buffett's Berkshire Hathaway).

But, in that period, the Sequoia fund underperformed the S&P 500 10 times, or 37% of the time. The numbers are similar for other focus investors named in the book, such as Buffett's partner Charlie Munger, whose partnership returned 24.3% on average annually compared to 6.4% for the Dow Jones Industrial Average. Yet, Munger's partnership underperformed the Dow 36% of the time.

When it comes to price performance, bad years are part of the deal. Count on it. Also understand there is significant risk in a focus strategy. As Hagstrom says, it takes the right temperament, plenty of elbow grease, and a long-term time horizon. But, we don't let volatility tease us into placing our capital in companies we don't believe in. Do you?

Time to Sell Gap?
As many of you know, we're trying to decide whether to sell Gap here in the Rule Maker portfolio. Tomorrow, Phil Weiss will give you his thoughts on the topic, but for now, readers should check out Motley Fool research analyst Bob Fredeen's story on the very same subject. Bob, who argues now is the time to buy Gap shares, not sell them, has been covering Gap for The Motley Fool since March.

Have a great day.