Introduction to Stock Portfolio Diversification

Much is said in the popular investing media about the benefits of diversifying a stock portfolio. Fund managers routinely extol the virtues of diversification to protect the investor's portfolio from volatility and paper and realized losses. Modern portfolio theory urges investors to diversify according to their level of risk. On the other hand, Warren Buffett tells investors to concentrate on stocks they know well. His "focus investing" approach leads investors to place bets on a few stocks with the expectation and hope of picking big winners. We urge the committed investor to achieve a blend of focus and diversity, and not accept either pure mode as appropriate to your situation and goals.

Pros and Cons of a Broadly Diversified Portfolio

A broadly diversified portfolio has enough stocks in it so that its performance is highly correlated with the broad market or a selected sector index. For example, a very broadly diversified portfolio is one with all or most of the S&P 500 stocks. A broadly diversified sector portfolio is one that includes, for example, all or most of the semiconductor stocks in the Philadelphia Semiconductor Index (SOX).

The advantages of a very broadly diversified portfolio are:

The disadvantages of a broadly diversified portfolio are:

Pros and Cons of a Focused Portfolio

A focused portfolio includes fewer stocks than a broadly diversified portfolio. Usually the focused portfolio includes 20 or fewer stocks. Of course, the number of stocks upon which you can focus is limited by your time and other resources. If you can focus on 20 or more stocks, you can have some of the benefits of diversity and focus combined.

The advantages of a focused portfolio are:

The disadvantages of a focused portfolio are:

Common sense suggests that if you consistently pick winning stocks, you don't need to own many stocks to achieve high returns. In fact, diversification can reduce your returns if you combine lower-performing stocks with your winners. However, if you have difficulty picking winners, you should add more stocks to your portfolio with the expectation that some of the additional stocks will improve the performance of your portfolio.

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