Why Smart People Diversify

If you've spent any time reading or listening to financial fare, you've surely heard references to diversification. Here's a look at why diversification matters to you and your portfolio.

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The case against diversification

First off, know that diversification isn't always embraced. Self-made billionaire Mark Cuban has saidthat portfolio diversification "is for idiots," while none other than Warren Buffett hassaid: "If you are a professional and have confidence, then I would advocate lots of concentration. ... If [investing is] your game, diversification doesn't make sense. It's crazy to put money into your 20th choice rather than your first choice." Buffett has also quotedBilly Rose, saying, "If you have a harem of 40 women, you never get to know any of them very well."

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His words make plenty of sense. After all, the more money you put into the fastest growers, the better your portfolio will perform. There's a catch, though. It's far easier said than done to successfully identify the best investments, and many smart people have lost money trying. Even Buffett concedes, saying:

Diversification can also be difficult if you're investing in many individual stocks, as that will require a lot of time to study them and keep up with their progress. Buying and selling them can also generate significant trading costs and taxable gains, if you trade relatively frequently.

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Why diversify?

A clear reason to diversify is so that you don't have all, or most, of your eggs in the same basket. You may be very sure that a certain stock will perform well over time, but you could be wrong. Few ever imagined that General Motorswould ever declare bankruptcy, or that the investment company Lehman Brothers, which tracedits roots back to the 1800s, would go out of business.

If you split your portfolio equally between two stocks and one falls by 50%, your portfolio will take a 25% hit. If instead you hold 10 stocks equally and one falls by 50%, your portfolio will suffer only a 5% haircut. (Of course, such diversification can restrain not only big losses but also big gains.)

As you consider how concentrated or diversified your holdings are, be sure to take into account any stock you have in your employer. If a big chunk of your retirement assets is sitting in your employer's stock, that can be dangerous -- because then you're relying on your employer not only for your current income, but also for your future financial welfare. If the company were to fall on hard times, you could conceivably lose your job and also much of your nest egg. That's what happened to many Enron employees when it imploded.

Enron also serves to remind us that while, yes, we tend to be very familiar with the companies we toil for, we can't be sure of how well they'll perform. Many smart people had lots of confidence in Enron, but they were all wrong.

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What to do

If you have the time, skill, and interest required to study, select, and invest in individual stocks, you should aim to have a diversified portfolio, ideally holding a mix of companies in different industries and perhaps in different countries as well. Including some bonds in the mix adds further diversification, though the younger you are, the less you might keep in bonds, as they tend to grow much more slowly than stocks.

An excellent alternative to all that is simply to opt for one or more low-cost broad-market index funds, such as the SPDR S&P 500 ETF (NYSEMKT: SPY), which distributes your assets across 80% of the U.S. market. The Vanguard Total Stock Market ETF (NYSEMKT: VTI) or the Vanguard Total World Stock ETF (NYSEMKT: VT) will, respectively, have you invested in the entire U.S. market, or just about all of the world's stock market. There are index funds for bonds and real estate, too, such as, respectively, the VanguardTotal Bond Market Index Fund(NASDAQMUTFUND: VBMFX) and theVanguard REIT Index Fund (NASDAQMUTFUND: VGSIX).

Even Buffett, as we've seen, has recommended index funds for "non-professional" investors. In his 2013 letterto shareholders, he noted: "The goal of the non-professional should not be to pick winners ... but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal." Since most managed stock mutual funds underperform their benchmark indexes, you're not even settling for poor results with index funds.

Most of us are not the savviest investors, so diversification can serve us well.

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Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, holds noposition in any stocks mentioned. The Motley Fool recommends General Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.