Warren Buffett on Diversification

Diversification is only required when investors do not understand what they are doing...

I get angry when a well-respected person preaches the value of diversification. The only excuse for being diversified is ignorance. Let me explain by posing this question:

• If a loved one were experiencing the symptoms of a heart attack, would you be more confident taking them to a general practitioner or to a seasoned cardiologist?

I personally invest in individual stocks, but I'll be the first to admit most people shouldn't do this. For the average person, regularly investing in an index fund that tracks something like the S&P 500 is all it will take to beat 90% of all mutual funds out there. Seriously... most actively managed funds under-perform the markets after expenses.

When I first started investing, I held between 20-30 stocks at a time. These were the hot stocks I read about and wanted to own. The problem was, I knew very little about any one of these companies. Besides that, I was paying more in transaction fees to own these stocks than I was paying for electricity to power my home. Seriously.

The disciplined investor will likely do fine owning just 5-10 stocks. If you are doing the appropriate amount of research, there's no way you can keep up with any more than this unless you are a full-time investor.

I learned a lesson about the harm of diversification when I opened an account at Prosper.com. In fact, the CFO and other higher ups at Prosper preached the values of diversification on their blog and at the Prosper Days conference I attended a few years ago. Prosper is a micro-lending site where individuals can ask other individuals to borrow money. The folks at Prosper encouraged lenders to "spread the risk" by lending to several borrowers instead of 1-2. I was lending $50 at a time to dozens of borrowers, and doing little more than looking at the interest rate being offered. Instead of making 20 loans for $50 each, I most likely would have done better by making a single loan for $1,000 (or, at most, 4-5 loans total). If I had taken the time to really learn more about the borrower, I could have spent time really vetting out who to lend to.

Take the time to really understand how the company you are researching makes its money. You'll still make mistakes from time to time, but I'm betting your performance will be much greater than simply throwing money at a couple dozen "hot stocks."

Next up... How I research a stock.