In one of his many conversations about investing, Berkshire Hathaway (NYSE: BRK.A) Chairman Warren Buffett has advised folks to approach investing as though holding a punchcard that allows for 20 investments over a lifetime.

Twenty picks, one lifetime. Better make them count.

This is our approach in the Rule Maker Portfolio. Buy a small handful of the world's best companies and hold on for the long haul provided the businesses continue to perform and management channels the rewards to shareholders.

This isn't the way many very bright people approach investing. In fact, it's opposite the approach espoused by most investment professionals, who recommend wide diversification in different types of securities, markets, indexes, and countries. I don't think diversification is a bad idea, not at all.

In fact, Roger Ibbotson, finance professor at Yale University and founder of Ibbotson Associates, has said that more than 90% of an investor's total returns is determined by the asset categories that are selected. This means less than 10% of performance is determined by specific stock and mutual fund picks, according to Ibbotson. You couldn't find an approach more different than ours in the Rule Maker, and it's important to know we're out on a limb relative to conventional, academic thinking. Our approach may sound simple and sweet, but don't kid yourself that it's tame or without risk.

Ibbotson has been crunching numbers and providing investment professionals with market data and research for more than 20 years. I take seriously what he says, and I consider diversification through index funds to be an extremely shrewd investment strategy. Actually, I'm becoming more and more convinced that index funds are the way to go for the average investor -- low cost, market-matching returns, tax efficient, and easy on the brain.

If you're hankering for a little more, the Rule Maker strategy is an approach grounded in many of Buffett's ideas: We are looking to purchase great companies at reasonable prices. We started out buying great companies, regardless of price, yet we've come around. Buffett came around a little, too. He started out buying good companies at great prices, and now looks for great companies at good prices. We both stress quality.

The fact remains, however, that Rule Maker investing is risky. Remember, we don't believe volatility measures risk in the Rule Maker portfolio. This is another Buffett idea: risk isn't determined by how much a stock varies in price from year to year. It's determined by the likelihood that a business will fail to produce the kind of cash we expect it to produce over time. But volatility does equal risk if it will prod you into selling a stock you believe in -- and it's easy to underestimate the persuasiveness of the court of market opinion.

Many academics, such as Ibbotson and Burton Malkiel, recognize this tendency in the average investor and turn it into a strength by nodding to index funds and diversification. The average investor doesn't have the same insight into investing Buffett does. This makes volatility a tougher storm to endure. Say you buy a company and the wind starts blowing. Is that roar against the window sash coming from the company you just bought or the current market? It can be hard to hear the difference. 

For investors such as these -- and there's no shame in it -- the Rule Maker is the wrong strategy. It's much too risky, and by that I mean volatile. Only investors very interested in learning about business and investing should step out and sample the Rule Maker approach. If you're not interested in learning more, why bother? Put additional money into your index funds and let the (historically) steady market winds carry you forward. It's a lot easier to stay the course with the market than with one or two lonely little companies.

Buffett's view of diversification is that it's simply an admission you can't pick stocks. If you can't choose businesses well enough to beat the market, might as well diversify and match it. Over the long term, if the Rule Maker punches its card carefully, I think we have a good chance of beating the market. We haven't done so yet, but hey, we're not even to the first turn. We have to invest in established companies with visible futures at good prices. We'll get four yards and a cloud of dust, over and over, for years to come. This is the punchcard approach.

And by the way, if you want to take some time to build your skills in discerning the great businesses from the rest of the pack, I hope you'll consider joining us for our upcoming Rule Maker 2001 online seminar, The Art of Rule Maker. For $49, you can't beat the business and investment education you'll receive. And if you don't have a blast, we'll give you your money back. That's a card worth punching.

Have a great day.

Richard McCaffery, a co-manager of the Rule Maker portfolio, lives near the horse-racing track in Laurel, Maryland with his wife Linda. You can view his stock holdings in his online profile. The Motley Fool is investors writing for investors.