On Efficient Diversification

If you ask any stock expert worth her salt what the most important rule of investing is, you will more than likely hear her chime, "Diversify!"

But what really does diversification mean? And how many stocks makes a diverse portfolio? We will examine these questions, and, in the process, introduce the concept of efficient diversification.

What does Diversification mean?
From a stock investing perspective, diversification simply means buying stock from different companies so you have a "diverse", well-rounded portfolio. Diversification ensures that all your money is not concentrated in one or two stocks or in multiple stocks within one industry.

The chief reason for diversification is to reduce your investing risk.

Does Diversification Work?
Diversification is a great tool — if you don't really know the companies you are investing in that well.

Let's look at it this way... to be "truly" diversified, as the pundits put it, you need to own stock in at least 30 companies, maybe as many as 100. You could as well be running a mutual fund!

How many individual investors have the time and resources to keep track of so many companies in their portfolio?

So diversification certainly does what it's intended to do — minimize your investing risk. But, quoting Warren Buffett, this "risk comes from not knowing what you are doing."

The Case for a Concentrated Portfolio
Now if you are picking stocks based on good, solid fundamental research, and demanding strong margins of safety in your price, you are already taking giant steps in mitigating your risk. In addition, due to the inherent fundamental nature of your stock-picking, you will be tracking the developments in these companies like a bloodhound.

If you build a portfolio this way, you only need to own a handful of companies. Certainly not just one or two because even the best methods cannot insulate you from damaging, unforeseen future events that can wipe out your investments. At the other end of the spectrum, 30 companies is not doable at all for the normal, individual investor.

5 to 12 companies at a time strikes an achievable balance. This is a concentrated portfolio, also called efficient diversification.

Bottom line..... buying fundamentally strong companies at attractive prices doesn't require you to mindlessly diversify your holdings. Focusing on less than a dozen companies will yield results far more favorable than over diversifying yourself into mediocrity.