Warren Buffett knows how to invest. As chairman and CEO of conglomerate Berkshire Hathaway (BRK.A 0.55%) (BRK.B 0.50%), he has generated billions in investment gains for himself and Berkshire shareholders.
Interestingly, a quick review of the Berkshire Hathaway stock portfolio shows a striking lack of diversification. Some 75% of the conglomerate's stock holdings are concentrated in five domestic companies that operate in four economic sectors: Apple, Bank of America, Coca-Cola, Chevron, and American Express.
Given Buffett's track record of savvy investment decisions, you have to wonder why he doesn't spread out his risk more. If Buffett can do well without diversification, can you too?
Buffett on diversification
Buffett has described diversification as "protection against ignorance." And he's not wrong. Diversification is a risk-management strategy. You give yourself exposure to different stocks -- or sectors, asset classes, and geographies -- to ensure that no single one of them can bankrupt you.
There is a trade-off, however. The point of diversification is to offset losses, but you'll also offset some gains in the process.
Buffett isn't one to compromise on gains, probably because he doesn't have to. He has a few factors working in his favor. Sadly, his advantages don't apply to most investors:
- Buffett has 80 years of investing experience and an unusual knack for picking good businesses. His nickname, "Oracle of Omaha," says it all.
- Berkshire Hathaway has a conservative balance sheet, with $30 billion in cash and cash equivalents, plus another $75 billion in Treasury bills.
- Outside of its stock portfolio, Berkshire Hathaway is a majority owner in more than 60 companies.
Why you should diversify
If you had Buffett's skill and funding, you might do alright with concentrated positions in just a few stocks. But it's very likely you don't have Buffett's expertise -- or billions in cash to back you up. In that case, diversification is a must. If you can't absorb catastrophic losses, take steps to prevent them.
You diversify across individual stocks to lessen the risk of each. You invest across multiple industries so that no input shortage or regulation change can sap your portfolio's value. You can also put your money into different economies for protection against a downturn here at home. And you can diversify into other asset classes -- say, cash and bonds -- for insulation against stock market crashes.
How to diversify
As a guideline, look to hold at least 20 individual stocks across different industries plus a percentage of cash or cash equivalents.
Or, for an easier alternative, invest in two or more index exchange-traded funds (ETFs), which help you diversify with less work. This strategy can be as simple or as complicated as you want it to be. A good starting point is a low-fee S&P 500 fund plus a short-term U.S. Treasury ETF. To that, you could add on funds for exposure to U.S. small caps, international developed countries, emerging markets, real estate investment trusts (REITs), alternative assets, and more.
Earn more money another day
Diversification smooths out your investment results and protects against the biggest of losses. Unless your nickname is "Oracle" or something similar, that protection is critical because you won't always make the right choice. When that happens, diversification keeps you in the game to earn more money another day.