What Warren Buffett Says About Diversification May Surprise You…
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
This quote comes from Warren Buffett, who is famous for investing in a small number of stocks and holding them for the long haul. As a strong advocate for tightly concentrated portfolios, Buffett believes that holding too many stocks can water down your returns.
How many is too many? Well, he has argued that six wonderful businesses are all you need, adding that “very few people have gotten rich on their seventh-best idea.”
He practices what he preaches. While Berkshire Hathaway has ownership interests in about 46 companies, the lion’s share of the portfolio (nearly two-thirds) is invested in just a few names names. The biggest is Apple, followed by Bank of America, American Express, and Coca-Cola. Buffett isn’t afraid to make colossal investments in a small handful of positions. And with few exceptions, these big bets usually work out brilliantly.
Of course, we’re also talking about the most astute stock picker of all time. For those without his legendary skills, this strategy might be far less productive — possibly even dangerous.
Even Buffett Makes Mistakes
Until recently, Buffett’s single largest position was in Wells Fargo. You have probably seen the bank in the news lately — for all the wrong reasons. Wells Fargo has been embroiled in an embarrassing scandal involving the creation of millions of fake, unauthorized customer accounts.
The backlash from these deceptive sales practices and weak corporate governance has been severe. Over 5,000 employees were given the ax, and the company has set aside more than $3 billion to cover anticipated fines and legal costs. Several board members were nearly ousted and kept their jobs only by the skin of their teeth.
Innocent shareholders have also been stung by the ongoing probes and sanctions, losing billions in value.
Similarly, the Kraft-Heinz merger that Buffett helped engineer hasn’t worked out so well, either.
Which brings me to my point… If even Warren Buffett couldn’t see these wrecks coming, then how can the average Joe be expected to steer clear?
The hard truth is we usually can’t. Unless you want to park all your money in safe bank CDs paying next to nothing, investing in equities sometimes involves unexpected setbacks.
A Punch In The Gut Could Be Waiting Right Around The Corner
This isn’t really about Wells Fargo or Kraft Heinz. The fact is, punishing stock declines of 20%, 30%, or more happen all the time, for a wide variety of reasons. Some can be seen a mile away, but others are abrupt and unavoidable.
That’s why I advocate spreading your assets more judiciously among a larger number of holdings so one or two torpedoes won’t sink your entire portfolio. With rare exceptions, I seldom advise putting more than 5% of your money in any one position.
Sure, I will invest more in certain high-confidence picks than others, but without going overboard. This might limit the overall impact that a triple-digit winner makes in my High-Yield Investing portfolio — like the 156% gain we made on CME Group (Nasdaq: CME) when we sold — but it will also soften the blow from a laggard.
Why is this important?
Because Buffett can afford to take a billion-dollar hit. You and I must be more cautious.
Ironically, this safer approach can also yield better returns. Morningstar conducted a fascinating study to analyze the correlation between portfolio size and returns. It analyzed thousands of mutual funds grouped only by the number of portfolio holdings, with no other variables, and then compared their performances.
Morningstar found that the most concentrated portfolios (between 1 and 29 stocks) generated the lowest five-year returns, while the most diversified (250 stocks or more) produced the highest returns. They were separated by 17 percentage points in terms of average percentile ranking.
Action To Take
Now, I’m not saying you need to call your broker and place buy orders for two hundred stocks tomorrow. Even fifty can be unwieldy and difficult to keep close tabs on. The point is this: be careful betting most of your chips on just one or two hands.
In my High-Yield Investing premium newsletter, we own about 30 stocks and funds at any given time. They span a cross-section of industries, sizes, and geographic regions. That’s close to a maximum for me. So with new prospects knocking on the door to get in, I may cash out some gains here and there to make room.
If you’d like to join us in our search for the best high yields the market has to offer, then I want to invite you to learn more. You don’t have to settle for the paltry yields offered by most stocks. The high yields are still out there… you just have to know where to look. And my staff and I are here to help you along.
That’s why we released a special report about 5 “bulletproof” dividend payers that every investor should consider having in their portfolio. Go here to learn more.