Diversification is a Protection against Ignorance

Its rare these days to find an investor who is completely satisfied with his or her own portfolio. Some cry for that they have made poor investment choices during the bull market and failed to keep pace with indexes. Many investors have criticized themselves for following a craze trend that went bust. Probably the most common problem I've encountered has to do with diversification. Few investors have developed any sort of strategy for blending and balancing stocks within their portfolios. At its worst manifestation, some investors have hoarded stocks like vases and own shares in dozens of companies. Some own more than a dozen mutual funds, several of which may hold the same types of stocks. They take diversification to the extreme to feel safe.

However, diversification is the bane of high returns. A tiny percentage of professional investors have been able to get a market-beating track record over long periods by owning dozens of stocks. A fund manager who obtains an 80 percent 1-year return can live off that one period for several more years. Even if his performance lags in subsequent years, the 80 percent one-time return is usually enough to keep the portfolio above the Down Industrials or S&P 500 for several years.

Warren Buffett and Philip Fisher have no use for diversification. They are wholeheartedly aware that diversification poses no long-term benefit to a portfolio and drags down potential returns. 'Diversification is a protection against ignorance,' Buffett told investors at the 1996 annual meetings. The more stocks one owns, the more difficult it is to keep track of one's winners and losers and to keep a pulse on the financial performance of so many companies. Moreover, it gets exceedingly difficult to boost yearly returns above expectations. Once you own 30 or more stocks, boosting returns is as difficult as spinning around a Carnival cruise ship in Miami harbor.

To improve your chances of beating the market, you must keep your portfolio small.