Is Diversification Important

What is Diversification? And Why Warren Buffett is Wrong.

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Why 99% of investors need diversification, even if Warren Buffett doesn't

Why does Warren Buffett say diversification is only for people that don’t know what they’re doing…and why is he wrong?

In this video, I’ll show you how diversification helps you reach your investing goals and why it’s essential for 99% of investors out there. Then I’ll show you a strategy to get instant diversification plus higher returns.

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Why Does Buffett Hate Diversification?

Nation, this is going to be a controversial video. I know there are a lot of Buffett fans out there and he may be the best investor of all time but in one idea, he’s flat out wrong.

Buffett has said that diversification is only needed when you don’t know what you’re doing. He has said that only stock concentration builds wealth. Hell, Mark Cuban has even gone so far as to say that Diversificaion is for idiots.

But these guys are wrong because they’re looking at it from the billionaire’s perspective and I’m going to show you why every one of us in the Bowtie Nation, myself included, needs diversification in our investments.

I’ll start by showing you what is diversification, sharing a couple of diversification examples, then explain why Buffett has never been more wrong. Then I’ll reveal a strategy that makes diversification easy and still lets you pick stocks for market-busting returns.

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What is Diversification?

Diversification is a fundamental component of the modern global economy. It's more than just spreading your money around, however. By diversifying an investment portfolio properly, many risks can be eliminated and you could potentially make more returns on your investment capital.

What is diversification? Simply put, it's making sure that whatever investments you have in your portfolio are not all in the same or similar investments. For instance, if you have 3 stocks and they're all pharmaceutical companies, your portfolio isn't diversified. If you have 5 stocks and they're all technology companies, none of which overlap (Apple, Google, Microsoft, etc…), then you have a diversified investment portfolio.

Why is diversification important? To start, there are many different types of investments one could make and it's entirely possible to lose money on ALL of them. In the event that an economic collapse happens in the US or other major world economy, real estate prices could plummet for a decade or more. In the 2008 collapse, investors who were heavily diversified on paper lost a huge percentage of their investments but even those who had no diversification whatsoever also lost money (in some cases nearly 100%). Diversification is important because it could potentially protect you in such an event.

So diversification just means having a combination of investments so you don’t lose all your money when shares of one stock take a nosedive. It can mean holding different stocks, it can mean different assets like stocks, bonds and real estate, basically just not having all your proverbial investment eggs in the same basket.

For example, if you had all your money in shares of Tesla, you’d be feeling pretty good for a while there with a huge return but then what happens when shares go the other way?

Is Diversification Important
Is Diversification Important?

And everyone likes to think they would just hold on until shares bounce back higher but the fact is many investors end up panic selling at exactly the wrong time. They buy in as shares are heading higher then sell on the way lower, making for a huge loss.

By investing in different stocks, bonds and real estate for that diversification, your portfolio doesn’t rise or fall with just one investment. If we look at this chart of the Vanguard Balanced Index Fund, that’s a fund made up of 60% stocks and 40% bonds, in green and the stock market S&P 500 index in red from 2000 to 2014, you clearly see the effect of diversification here.

Diversification Example
Diversification Example

Now the S&P 500 is pretty well diversified across those 500 stocks but it’s still exposed to that roller coaster anytime a stock crash comes along. By just putting less than half of the investments in bonds, you could have had a lot fewer sleepless nights in 2002 and 2008.

That’s not to say you wouldn’t have seen your portfolio fall at all but the stress that causes investors to panic sell at the bottom wouldn’t have been there. You could have taken advantage of the lower stock prices to sell some bonds and buy into the market and you would have made even more money!

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Pros and Cons of Diversification

So let’s look at some pros and cons of diversification then I’ll explain why our billionaire buddies are wrong, then reveal that strategy for diversification.

Pros of diversification are that you get to take advantage of whatever trend that comes along. Whether tech stocks are surging or gold is taking off, you’re more likely to benefit because you have a range of investments.

As we’ve talked about diversification also smooths out that crazy roller coaster ride when stocks fall. You’re less likely to worry about your money and less likely to make those bad investing decision.

Diversification also gives you the opportunity to rebalance your portfolio and take advantage of lower prices. When stock prices fall, you can sell some bonds and buy into a cheap market. When the market surges, you can sell some stocks to buy cheaper real estate or other assets.

But diversification isn’t the miracle cure for making money either. The downside, and this is the main point Buffett makes, is that your total return is smoothed out by winners and losers. Just like you don’t lose half your money when Tesla crashes, you also don’t see your portfolio double if the shares rebound.

Case in point, our 2019 Dividend Portfolio Challenge we put together in January is beating the market with a 25% return but look at what it could be doing if we had everything in just Hanesbrands with a 154% return or even General Mills with a 92% return so far this year.

So you do sacrifice some potential in exchange for that smoother, less stress strategy in diversification.

The problem with Buffett’s thinking here is that he’s speaking from the perspective of a portfolio manager. Buffett has an army of analysts looking at stocks. He’s got $128 billion in cash that he can jump into stocks if prices fall. He can literally buy an entire company as an investment.

It’s a completely different kind of investing for you and me.

I’m guessing, now tell me in the comments if I’m wrong, but I’m guessing you don’t have analysts digging into financial statements all day. I’m even guessing you don’t have all day to pick individual stocks.

Even your bowtie buddy here, I don’t have all day to pour over financial statements like I did in my analyst days. I might spend ten or fifteen hours a week reading market news and picking stocks. The rest of the time, I’m putting together videos or blog posts or picking out ties.

Another difference here is that Warren Buffett is cursed by his own success. His Berkshire Hathaway has produced a 13% annual return over the last three decades versus a return just under 7% on the market.

But now investors expect it. Buffett can’t use diversification, he can’t invest in a lot of companies and get that market return because he has to beat the market. Slip and get the market return for a year and investors wonder what’s wrong with Warren.

You and me though, our problem isn’t beating the market and making our investors happy. Our problem is avoiding the big mistakes, our goal is making money when the market rises and not losing it when stocks crash.

That’s how regular investors win the stock market game and the way you do that is with diversification! You invest across different stocks, different assets and you take advantage of the benefits to diversification we talked about.

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How to Diversify Your Stocks

Now that we’ve seen WHY diversification is a good thing and why Buffett can stop calling me constantly trying to argue the point, now I want to show you how to create a diversified portfolio for a stress-free investing strategy that’s going to meet your goals.

When you think about creating a diversified portfolio, so you want a well-rounded group of investments that will give you a good shot at market returns and maybe a little extra, you want to think in terms of two or three ways you can diversify.

First here is by asset class. This means making sure you have stocks, bonds and real estate in your portfolio. These three types of investments all react differently to the economy and other forces so bonds are going to save your ass when stocks plunge. Real estate is going to do well when inflation wrecks your bond investments and stocks will provide those oversized returns when the economy grows.

Investing in stocks, bonds and real estate is like being able to throw rock, paper and scissors all at once!

Second, you want to make sure you invest in stocks from different sectors. These are groups of companies, all from a part of the economy like tech or utilities or consumer staples. Each sector responds to the economy differently and has different characteristics. Tech stocks and Financials tend to boom when the economy is doing well. Utilities and consumer staples are safer during a recession because they sell necessary products.

This doesn’t mean you have to invest blindly across every sector either though. We just finished up an 11-video series picking the five best stocks from each sector. The idea is that you can get that diversification, you can get investments across many sectors that will help protect you from a crazy stock market, but you can also still get that higher return by picking individual stocks.

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Foreign Stocks for Diversification

Another way to think about diversification before we get to that strategy to make this all easier is going to be in terms of geographic diversification.

This is one that is sorely missed by most investors. We have a bias towards stocks of companies based in our home country and it’s really a lost opportunity.

Investing in stocks of foreign companies not only helps to smooth your portfolio away from domestic market crashes but also from changes in exchange rates and interest rates.

For U.S. investors, getting a little foreign exposure is easy through American Depository Receipts which are just stocks of foreign companies that trade on the American exchanges. You can buy shares of Alibaba or BP just as easily as you could shares of Amazon or Exxon Mobil.

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My Favorite Investing Strategy for Diversification

Now to that strategy to get all the diversification you need plus the opportunity to pick stocks and make a little extra return. This is something we’ve talked about on the channel before but it’s critical for this idea of lowering your risk in the market.

The strategy is called core-satellite because you have a core of investments that make up between 60 to 75 percent of your portfolio. These are in exchange traded funds, ETFs, or other funds that cover a group of investments.

For example, you might have 15% of your money in the Vanguard Real Estate Fund, ticker VNQ, which holds shares of companies in the real estate sector. Maybe you hold another 10% of your money in the Vanguard Long-Term Bond ETF, ticker BLV, which invests in hundreds of bonds and pays a 3.3% dividend.

Finally, maybe you hold another 50% of your portfolio in a few funds like the ProShares S&P 500 Dividend Aristocrats ETF, ticker NOBL. This one holds shares in the best dividend stocks in the market, shares of 57 companies all in one fund.

So by investing most of your money, that core sixty- to seventy-five percent in three to five funds, you get instant diversification across stocks, bonds and real estate. You money is spread out across hundreds of stocks, you’ve got bonds in the bond fund and cash flow from the real estate fund.

Then with that satellite portion of your portfolio, the remaining 25% or so of your money, you invest in individual companies that your really think could produce those higher returns.

This is where you get in touch with your inner Warren Buffett for picking stocks and getting those higher returns. You’re following trends in the market, you’re digging into the financial statements and finding those companies with a competitive advantage and underappreciated shares.

The beauty of this core-satellite strategy though is that because you only have that 25% of your money to invest in these individual stocks, and say you invest three- to five-percent of it in each stock, that means you’re only picking maybe eight to ten individual stocks. So instead of having to find 20 or 30 stocks, doing the hours of analysis on each one and keeping up-to-date on each one, you only need a handful of winners.

This is going to cut in half the amount of time you spend looking for stocks to buy and following your investments. You don’t have to worry about those three to five funds you hold. They’re diversified across a group of stocks, bonds or real estate so they’ll be getting that average return on the investment. All you have to do here is look at your portfolio maybe once a year or so to make sure the percentages of your money are still about right in that core part of the portfolio.

For example, maybe you start the year with 45% of your money in the stock funds, 10% in a bond fund and 20% in a real estate fund. After a year or two though, maybe the stocks have taken off and you’ve got 55% of your money in those funds and only 7% in the bond fund and 17% in the real estate fund. This is where you would go back in and rebalance that, selling some of the stock funds to buy more of the other funds and bring everything back to your target percentages.

That’s going to leave you with a lot of time to finding those few individual stocks you need or just to not worry about your money. Spend maybe a couple of hours a week keeping up-to-date with your stock picks and know that you’ve got that mix of diversification and extra return with this strategy.

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Stock diversification is critical for Main Street investors even if billionaires like Warren Buffett and Mark Cuban don't think so. It's easy to set up a diversified portfolio that will not only protect your money but grow it as well.

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