Will asked "Is there anything wrong with adding a certain level of diversification? Maybe split up your capital across 3-5 different companies in different industries? Isn't diversification considered the only free lunch? I am not talking about a basket of 20 stocks. But doesn't some diversification make sense? I just think that you can do everything right and still have an unforeseen event sink your battle ship. Like a natural disaster that wipes out your company. Or a misinformed short selling attack out of nowhere that may be totally false but can wipe out half your investment."
The short answer is that diversification in general is overrated but 3-5 businesses is hardly diversification by the standards of the financial services industry. If you are managing someone else's money and are not a genius and do not want to be criticized by their accountant, you'll spread their money across cash, bonds, real estate, commodities and stocks and call yourself a pro. And you'll also have about a snowball's chance of producing a significant return on invested capital.
If are managing your own money and want to be and stay rich, I’d recommend doing what the best investors in the world do - focus your portfolio on businesses you understand that you know you are buying cheap and let the diversification happen naturally.
It is worse to be in things you don't understand than to be un-diversified in industries you do understand. If you're doing your work well, you shouldn't have an industry-wide permanent bad surprise. [NOTE: This assertion does not extend to the tech industries. It is in the nature of tech to have massively disruptive technology appear as if out of nowhere. Beware tech for that reason. It also does not extend to fraud. If your CEO is lying to you, you are screwed. That's why the third M is Management - honest, passionate, owner-oriented management.]
The number of stocks I own, and thus my diversification, such as it is, will ebb and flow as I find great businesses to buy. Sometimes I have ten stocks. Sometimes none. I buy real estate like I buy businesses. Same Rule One rules. And commodities like Gold? I hedge by trading like I showed you in my first book, Rule #1.
The amount you're investing matters, too. With $1000 you can buy one stock. Trading friction will eat up your return otherwise. With $100,000 you can do 5 to 10 if you can stay on top of that many. Lou Simpson ran Geico's $2 billion fund until last year. He had an average of 8 stocks.
For Rule One investors, diversification is a by-product of finding companies to buy. Company A is cheap, I buy it, it goes up and its not cheap any more and I'm done buying but I still have money to invest. I find Company B. It goes up and its not cheap any more and I'm done buying but I still have more money to invest .... And so it goes.
I’d argue that diversification is not at all a free lunch. I think it costs quite a lot in time and education to be able to successfully buy businesses in many industries and across asset groups. I think it’s a better, safer investment strategy to buy one right thing over and over again than many wrong things once.
Novice investors who are concerned about losing money on their first investment should not invest more than they can afford to lose. Or, even better, not invest at all. Just paper trade until their confidence goes up to a point where they sleep well at night knowing the bought a great company.
Getting to a place where you are comfortable takes time. If you are investing a million dollars that you can't afford to lose, you might take a few years to get to where you are comfortable with that responsibility. Until then, either sit in cash or diversify by buying market wide ETFs like SPY or trade carefully and gradually add great businesses that you know you understand.
Now go play.
