Diversification is a protection against ignorance. It makes very little sense.
– Warren Buffett
Almost every investing “expert” advocates diversification of one’s investments in the stock market. The recommendations come in a huge variety of forms, the most common being to hold stocks of many companies from different industrial sectors balanced by a certain percentage of fixed income instruments. In my earlier days in the business, brokers and money managers followed the 6:4:2 rule, i.e., 60% stocks: 40% bonds: tee-up at 2. (The 60% stock: 40% bond ratio would be adjusted in response to market headlines, hunches, whims, and wishful thinking; the tee time at 2 PM was a constant).
Fact: When a portfolio has more than 15 holdings, its performance will essentially be the market average.
Mutual funds & Diversification: There are more mutual funds than there are stocks listed on the exchanges, — ponder that for a moment. They average more than 100 stocks in their portfolios; furthermore, their average annual turnover of those stocks exceeds 80%!
How does that type of investing diminish risk? It doesn’t; I’m convinced, in fact, that it actually increases risk by diluting and diffusing holdings and the increased costs incurred by the excessive turnover decrease return.
A Value Investor (VI), on the other hand, realizes that the opportunity to purchase a superior business having a sustainable economic advantage at a market price less than its business value arises infrequently. The VI correspondingly concentrates as much capital as possible in such an investment and holds it indefinitely in order to obtain long-term compounding of the capital committed to it.
For the next week, I’ll post a daily quote by Warrant Buffett about diversification. The quotes are taken from the book, The Tao of Warren Buffett, by Mary Buffett and David Clark, published by Scribner in 2006.
