The viability of the term “diversification” is debatable. A diversified stock portfolio is a desired goal for most investors but not necessarily for purposes of achieving maximum results. As a matter of fact, the more diversified a portfolio is, the less chance it has for superior performance. On the other hand, the under diversified portfolio runs the risk of mistakes in stock selection, resulting in poor performance.
Diversification is a popular subject of debate. It even garnered the attention of the Nobel Foundation, which in 1990 bestowed upon Dr. Merton Miller of the University of Chicago its prize for his pioneer work in the field of portfolio diversification. No question about it, diversification is important; but left unattended, diversification can soon reach the point of diminishing returns, becoming a counterproductive force. I believe in diversification because I know I sometimes err in selecting stocks. But I also observe that through diversification, one major mistake will not prove fatal for an entire portfolio. Diversification is, however, a defensive rather than offensive tool. Putting all the eggs in one basket may be fraught with peril, but if it is a good basket, the eggs will fare well.
How much diversification should an investor have in a portfolio? The answer varies, but there are some basic guidelines. If a portfolio is invested in high-grade stocks, diversification is less important than if the stocks held are highly speculative. For a high-grade stock portfolio, I see no reason to own more than, say, ten or fifteen different issues. I have always believed in quality stocks, while at the same time recognizing that speculative holdings might produce superior results. Therefore, to the extent that some holdings are less than top quality, perhaps owning a few more is not a bad idea. One of the problems most investors encounter is the inability to stay current with more than just a few companies. I follow a long list of stocks and companies, but most investors do not. For those who have less time to devote to stock analysis, a good piece of advice is to hold as few stocks as is “comfortable,” to follow them closely, and to hold them if they continue to promise good long-term results. In fact, a good strategy for most investors considering purchasing a stock not currently in their portfolio is to consider buying only if they sell a stock they already own. This is a way of keeping a short list of holdings while concurrently comparing them with other potential investments.
Admittedly, this flies in the face of the practice of many institutional investors (in pension funds, mutual funds, etc.) who are dangerously over diversified. This is sometimes due to restraints placed upon these investors. Still other funds are so swollen with capital that the managers have no choice but to diversify, lest they control majority interests in hundreds of companies. Because a fund manager might have to buy too much stock of any one company to meet an investment objective, he will buy two, three, or four additional companies. This is part of the fault I find with most institutional portfolios. They are over-diversified and the results of those portfolios are average, at best, and most often below average.