Diversification: What It Is and Why It’s Important

Should you diversify your personal investment portfolios? There are two contrary opinions: 1) You should diversify your portfolio to reduce risks and smooth out returns over time, and 2) Too much energy is wasted worrying about diversification. It’s not only a waste of time, it waters down results.

Talk about two sides of the spectrum!

Academics in the nation’s business colleges are in the first camp. They teach the merits of diversification and spend a lot of time showing how it’s quantitatively the key to financial success.

Yet, many of the most successful and well-known money management professionals disagree and are firmly in the second camp.

For example, Warren Buffett has stated, “Diversification is protection against ignorance. It makes little sense if you know what you’re doing.”

Buffett’s right-hand man, Charlie Munger, has agreed with this sentiment, commenting, “The idea that very smart people with investment skills should have hugely diversified portfolios is madness. It’s very conventional madness. And it’s taught in all the business schools. But they’re wrong.”

If you know anything about Warren Buffett and his company, Berkshire Hathaway, then you know he doesn’t hesitate to take a significant position in investments he deems as great opportunities. He’s even dedicated as much as 40% of his entire portfolio to a single stock!

So, who’s right?

Let’s take a closer look at what exactly diversification entails, why it’s important, and whether it’s a strategy you should consider with your investment portfolios.

What Is Diversification & Is It Important?

Merriam-Webster defines diversification as: “the act or practice of spreading investments among a variety of securities or classes of securities.”

In other words, diversification involves investing across a variety of different types of investments. It stands in contrast to owning one company or a variety of companies in a single sector.

Diversification occurs at a couple of levels. Looking at your portfolio from the top-down, the first level of diversification occurs with the types of investments you own. Typically, we think about this as diversification at the “asset level.” At the highest level, this involves thinking about equity or ownership investments versus fixed income or lending types of investments. We often refer to this as stocks vs. bonds, with stocks entailing ownership and bond investors serving a lending capacity. However, ownership types of investment also include real estate, limited partnerships, and the like. Common to all ownership investments is that you have a stake in how the business does.

With lending or fixed-income types of investments, the investor owns a contractual agreement between themselves and the borrower. Bond issuers will pay you a contractually agreed amount over a period of time AND eventually pay you back the amount borrowed. We believe diversifying between equity and fixed-income investments is essential for investors because equity investments are, by their nature, more volatile over shorter periods and can be riskier. Typically, you should only dedicate money not needed for many years to equity investments.

Usually, fixed-income or lending-type investments are used by investors for money they need over the short-to-intermediate term.

Once you’ve determined the proper level of diversification between equities and fixed income, then you are left to decide what types of equity and fixed-income investments you should own. Here again, you need to think through whether you want to be diversified or not.

If you take the money you have dedicated to equity investments and put it all in a small number of assets, you should be sure you understand precisely what you are buying. Additionally, it is crucial to understand what is going on in the market, especially regarding the investments you are making.

It would be better for those of you who don’t have the time to research each investment and the market if you diversified your investments in equities. Without a clear understanding of when an investment is cheap (and why it’s cheap) or getting expensive (and why it’s getting expensive), you will be making decisions without a guide. You would far better achieve your goals if you just bought a portfolio of stocks diversified across the market.

Can You Own Too Many Stocks?

Now, if you’re looking to diversify your portfolio across several different stocks and industries, the next question on most investors’ minds is: how many stocks should you own? As you can probably guess, there’s a lot of varying opinions on how many stocks, bonds, and/or ETFs you should hold to diversify your portfolio properly.

Take Warren Buffett, for example. He once commented, “If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is going to be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea.”

On the other hand, Mason Hawkins of Southeastern Asset Management has stated, “Statistical analysis shows that stock-specific risk is adequately diversified after 14 names in different industries, and the incremental benefit of each additional holding is negligible. We own 18-22 companies to allow us to be amply diversified but have the flexibility to overweight a name or own more than one business within an industry.”

Again, there is no hard and fast rule on how many stocks or other securities you should own in your portfolio. What is essential, though, is that you’re not invested solely in one asset class.

What we often see in portfolios that new clients bring to us are portfolios built using mutual funds. Usually, people will buy several mutual funds to “diversify” their holdings. If you consider the fact most stock mutual funds own 100 or more stocks, if you own several, your exposure to the market can be measured in the hundreds of individual investments. We believe this is genuine “over-diversification.”

You can diversify your holdings of equities by having investments across an array of industries; in our opinion, the number you should own is directly tied to the level and quality of the work you’ve done in understanding each investment.

Interestingly, for all of Warren Buffett’s comments about diversification, his Berkshire Hathaway firm has a diverse collection of investments. It includes technology, financial, and energy stocks, auto manufacturers, ETFs, and even a couple of foreign plays.[1]

How Can You Start to Diversify Today?

The bottom line is that diversification may help limit your overall risk and ensure that you’re “not putting all your eggs in one basket.”

How you diversify your investments is a personal decision based on your financial situation and goals. And as you start to dig into different investment opportunities, we encourage you to do your homework. You should always understand the securities you are investing in, whether stocks, bonds, or ETFs, and determine the prospects of each investment and the potential of its industry, trend, and/or sector.

If you need help getting started today, don’t hesitate to reach out to us at Nicollet Investment Management. We’re dedicated to helping our clients develop custom portfolios that limit risk and maximize returns to help them achieve their financial goals.

Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment loss.

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Reference Articles

http://mastersinvest.com/diversificationquotes

https://www.reuters.com/business/nasdaq-ends-sharply-lower-tech-stock-sell-off-2021-05-04/

https://www.forbes.com/advisor/investing/what-is-diversification/.

[1] https://www.cnbc.com/berkshire-hathaway-portfolio/