Course 503: Diversification
The Best Approach
In this course
1 Introduction
2 Diversify a Little, Diversify a Lot
3 The Best Approach

Who’s right? Well, the answer depends on the investor. Think back to the college applications. There’s no right answer as to whether it’s best to write a few polished applications or mail out a dozen or more. For students who know where they want to go and can add value to their applications by spending time on them, the first option is better. For those who would be happy at any of a number of good schools and who can churn out quality work en masse, the second option is probably the best. Both sets of students may be pursuing their highest-return, lowest-risk option, given their desires and abilities. Likewise in investing. Assuming an investor has the time and knowledge to do research, it makes sense to focus on building a small portfolio of (potentially) great investments. Others may feel that finding those great investments is not worth the effort (or that it might be impossible to do so) and therefore choose to spread their investments far and wide. And, of course, there’s the whole range of positions in between. Keep in mind, though, that no matter how good a stock-picker you may be, a small portfolio will be the riskier course. Even a great focused investor such as Buffett can't elude risk. In March 2000, Buffett's Berkshire Hathaway was down nearly 50% from its early 1999 high. Eventually, it comes down to your risk and return trade-off and how much confidence you have in your stock-picking abilities. For the equity portion of an account, studies have shown that as few as eight to 12 stocks, whose returns are not highly correlated with each other, would reduce the portfolio risk to the risk level of the market. These studies are based on the average past performance. When looking forward, those portfolios with just eight to a dozen stocks will have results that are not as predictable as those of a portfolio made up of many more stocks.

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