What Buffett Says About Diversification Will Shock You

Working for StreetAuthority, I do a lot of different things.

In the course of a day, I may be writing an article... editing a newsletter... discussing potential picks with our staff... researching the next investing hotspot... even going over article ideas with Bob Bogda, our managing editor.

And with so much going on, I actually find myself a little frazzled as the day goes on.

To combat this, I've started getting to work about an hour earlier than the rest of the staff. I don't do this to show off, but found I can do more in that one hour (when I can simply focus on one task without distraction) than I could in two hours when the rest of the staff has the office buzzing.

Turning off the background noise allowed me to simplify things -- and get better results.

What does this have to do with investing? A ton.

Why diversification is like drinking from a fire hose Sometimes the investing waters are as clear as mud to retail investors. After all, there are literally thousands of potential plays out there.

You could try to play the exploding technology sector. You could day-trade the banks. You could stick with index funds and ride out any storm. You could even try to find companies that are simply undervalued and will rebound once the market notices.
 
But the problem is that there are too many options -- it's like trying to drink from a fire hose. Too many choices make it hard to nail down the one investment that will make your portfolio a winner.
 
Instead, like I do every morning by getting an early start, I think successful investors need to turn off the distractions and focus their attention to a small group of the best ideas... drink from a glass, instead of a fire hose.
 
By shrinking your portfolio, you'll find:
 
It's easier to stay on top of your investments -- If you have a portfolio of 50 stocks, how well can you pay attention to each one?
 
Even if you read up on each one just an hour each week, you'd have a full-time job (plus 10 hours of overtime) just to give each its due.
 
And with this market, it's more important than ever to watch your holdings. Instead, a portfolio of just 10-12 of your best picks would need significantly less time to track each week and you'll likely sleep better at night knowing you've done your homework.
 
Better portfolio performance -- Which do you think would average higher on a test: an entire class full of students, or a handful of the smartest students as picked by the teacher?
 
The answer is obvious... and it's the same with your portfolio.
 
Look through your holdings. If you have upwards of 30, 40, even 50 holdings or more, I bet you'll find some that you think are simply "OK." Hell, it wouldn't surprise me if you have some you don't even like but simply haven't sold yet.
 
Instead, what if you culled down your portfolio to just your favorite picks? Wouldn't your portfolio be in much better shape going forward? You'd have the cream of the crop, instead of the entire field. Remember, it's hard to outperform the market if your portfolio is the market.
 
That you're not alone in trimming down your portfolio -- Warren Buffett's Berkshire Hathaway (NYSE: BRK-B) holds just 37 positions. That's a lot for an individual investor, but for a company with billions at its disposal, it's surprisingly few. On top of that, in the past 25 years Berkshire's top five holdings have made up an average of 73% of its portfolio.
 
Buffett is simply a proponent for positioning a portfolio to take advantage of the best picks. He's even gone as far as saying:
 
"If it's your game, diversification doesn't make sense. It's crazy to put money into your 20th choice rather than your 1st choice. It's the 'LeBron James' analogy. If you have LeBron James on your team, don't take him out of the game just to make room for someone else."
 
If one of the world's greatest investor is following this approach, shouldn't other investors?

That's what I'm doing with $100,000

Buffett's school of thought is one of the main tenets of my Stock of the Month newsletter, and its $100,000 real-money portfolio. Think about it -- our economy and the markets still continue to run hot and cold. Investors are still skittish about unemployment, interest rates, housing... the list goes on.
 
But no matter what's happening, there are always some stocks doing well. And if you focus on a select group of your best picks, then you can profit.

One of my best performers in my newsletter, Olin Corp. (NYSE: OLN) gained 58% in about a year before I closed the position. Sally Beauty Supply (NYSE: SBH) had the same return. Hasbro (NYSE: HAS) gained 45.9%. And these returns were during what can at best be described as a "rocky" environment.
 
I understand that years of conditioning has led millions of investors to think diversification is crucial to success. And it is, if you want to simply match the market. But that's not what I -- nor Buffett -- want to do. I doubt you do either.

by Amy Calistri