Introduction to Portfolio Diversification

Much is said in the popular investing media about the benefits of diversifying a stock portfolio. Fund managers routinely extol the virtues of diversification to protect the investor's portfolio from volatility and paper and realized losses. Modern portfolio theory urges investors to diversify according to their level of risk. On the other hand, Warren Buffett tells investors to concentrate on stocks they know well. His "focus investing" approach leads investors to place bets on a few stocks with the expectation and hope of picking big winners. We urge the committed investor to achieve a blend of focus and diversity, and not accept either pure mode as appropriate to your situation and goals.

Pros and Cons of a Broadly Diversified Portfolio

A broadly diversified portfolio has enough stocks in it so that its performance is highly correlated with the broad market or a selected sector index. For example, a very broadly diversified portfolio is one with all or most of the S&P 500 stocks. A broadly diversified sector portfolio is one that includes, for example, all the semiconductors stocks in the Philadelphia Semiconductor Index (SOX).

The advantages of a very broadly diversified portfolio are:

One or a few poorly performing stocks do not significantly reduce the overall portfolio performance.
It requires less active management, with fewer buy and sell decisions, and attendant lower costs.
Performance is highly correlated with broad indices, either market or sector, and thus does well in a general up market.
Performance will be no worse than the broad market or index.

The disadvantages of a broadly diversified portfolio are:

An excellently performing stock does not significantly improve the performance of the portfolio, and thus large potential gains are missed.
Performance is highly correlated with the broad market or sector, and thus does poorly in a down market.
Performance will not be better than the broad market or index.

Pros and Cons of a Focused Portfolio

A focused portfolio includes fewer stocks than a broadly diversified portfolio. Usually the focused portfolio includes 20 or fewer stocks. Of course, the number of stocks upon which you can focus is limited by your time and other resources. If you can focus on 20 or more stocks, you can have some of the benefits of diversity and focus combined.

The advantages of a focused portfolio are:

An excellently performing stock significantly improves the performance of the portfolio.
It may not be highly correlated with broad market or sector and therefore may do well in a down market.
Performance may be considerably better than broad market or index.

The disadvantages of a focused portfolio are:

A poorly performing stock significantly reduces the performance of the portfolio.
It requires active management and may require frequent buy and sell decisions and costs.
It may not be highly correlated with broad market or sector. It may not do well in an up market.
Its performance may be worse than broad market or index.

Common sense suggests that if you consistently pick winning stocks, you don't need to own many stocks to achieve high returns. In fact, diversification can reduce your returns if you combine lower-performing stocks with your winners. However, if you have difficulty picking winners, you should add more stocks to your portfolio with the expectation that some of the additional stocks will improve the performance of your portfolio.

Conclusions and Recommendations

Picking winners is not easy. It takes experience, time, money, information, and a bit of luck. But the payoff from winners can be very large. If you consistently pick winners, there is little need to diversify. However, if you don't have the time or inclination to study and understand stocks, choose a broadly diversified portfolio. The committed investor will try to do better than that by using a blend of diversity and focus that fits both his or her skill level and financial objectives.

For more information about diversification read Diversification: Costs Can Outweigh Benefits.