Warren Buffett, known for concentrating his assets into a few key opportunities, has said that for those who know nothing about the markets, extreme
diversification makes sense. It’s vitally important that if you lack the ability to make judgment calls on a company’s intrinsic value, you spread your assets out among different companies, sectors, and industries. Simply owning four different mutual funds specializing in the financial sector (shares of banks, insurance companies, etc.) is not diversification. Were something to hit those funds on the scale of the real estate collapse of the early 1990’s, your portfolio would be hit hard.
What is considered good diversification? Here are some rough guidelines:
- Don’t own funds that make heavy sector or industry bets. If you choose to despite this warning, make sure that you don’t have a huge portion of your funds invested in them. If it’s a bond fund, you typically want to avoid bets on the direction of interest rates as this is rank speculation.
- Don’t keep all of your funds within the same fund family. Witness the mutual fund scandal of a few years ago where portfolio management at many firms allowed big traders to market time the funds, essentially stealing money from smaller investors. By spreading your assets out at different companies, you can mitigate the risk of internal turmoil, ethics breaches, and other localized problems.
- Don’t just think stocks – there are also real estate funds, international funds, fixed income funds, arbitrage funds, convertible funds, and much, much more. Although it is probably wise to have the core of your portfolio in domestic equities over long periods of time, there are other areas that can offer attractive risk-adjusted returns.
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