“Diversification is protection against ignorance.” – Warren Buffett
Warren Buffett is correct. But don’t let this statement trick you. Diversification is crucial for investors.
There is no doubt diversification is a hedge for ignorance… but no one is omniscient. Top managers and insiders don’t always know what’s happening in their businesses. Seemingly great businesses can go bankrupt quickly. Remember WorldCom, Enron and GM?… just to name a few.
Putting all of your eggs in one basket is unwise. One slip-up can devastate. To help remember why it’s so important, memorize the table below.
A 90% loss takes a 900% gain to breakeven… And a 100% loss can’t be recovered.
Warren Buffett doesn’t live by his quote above. His portfolio, Berkshire Hathaway, is widely diversified. It holds a candy company, railroads, banks, energy, insurance, communication, and technology businesses.
Risk is lowered by spreading your investments across assets. Smart investors know managing risk is just as important as returns.
Diversification prevents drastic changes in your portfolio over shorter time frames. Let’s say you are only invested in small company stocks. You then need to withdraw the majority of it to pay off unexpected health expenses.
During a bear market you sell out at a loss or depressed prices. But having a diversified portfolio will allow you to take out of the overvalued assets and keep the beaten down ones… Sell high and buy low.
It’s important not to put all of your eggs in one basket. A good rule of thumb is to put no more than five percent of your portfolio in any one investment. That way if it fails, other parts of your portfolio can make up for its losses.