"Diversification" and "dangerous" are two words rarely found in the same sentence. But they should be. That's because – if done incorrectly – it is exactly that. A double trouble mistake.
Warren Buffett – an oft quoted stock market guru and multi-billionaire who Foolish investors are more than familiar with – says: "Wide diversification is only required when investors do not understand what they are doing." He's right, but if diversification is done incorrectly, it's dangerous.
Too many advisors use diversification as a cop out. Just imagine if someone asked you about a topic you know little about. You can either say "I don't know" – the right answer – or waffle on with a heap of generalised statements which are sort-of correct. There is no room for the latter in your stock market portfolio. Buying 'sort-of' stocks which you know little about is a recipe for disaster.
A strategy better than diversification
The best risk management strategy you can use is even simpler than diversifying. Just know what you own and why you own it.
For example, Telstra Corporation Ltd (ASX: TLS) is a company every Aussie investor is familiar with but, as investors, it's imperative we know more than just the brand. Whilst I believe Telstra and Coca-Cola Amatil (ASX: CCL) would make good additions to most investors' portfolios, I don't believe the same can be said for Commonwealth Bank of Australia (ASX: CBA) or National Australia Bank Ltd (ASX: NAB) – two of Australia's most heavily traded stocks.
So if you thought, 'I need to diversify into blue-chips stocks' and bought either of the banks, in my opinion, that'd be more dangerous than not investing at all. After all, as the saying goes, patience doesn't lose you money.
How it works
Looking further into it, this strategy rarely costs you dearly because you'll only ever be buying good stocks at even better prices. I say rarely because we don't get it right every time. But by buying good stocks we set ourselves up for future success because we know what we own and why we own it – otherwise we wouldn't be buying it.
In addition, it doesn't matter how big or small a business is, the goal is to buy good ones. Companies such as Slater & Gordon Limited (ASX: SGH), Santos Limited (ASX: STO) and Collection House Limited (ASX: CLH) spring to mind. But many investors may refuse to buy Collection House because it has a market capitalisation of only $232 million. If you thought it was too risky two years ago, you've missed the opportunity for 117% capital gains and fully franked dividends.
If your diversification strategy didn't allow you to purchase it when it was cheaper and boasted more potential, you've got to reconsider your strategy. Savvy investors have to make nonsense of the general, but limiting, rules of finance to be ultimately successful. Picking four winners is better than picking six winners and two losers.
Foolish takeaway
My girlfriend once said I'm an "impulse" buyer. For gadgets and gizmos, she's probably right. But when it comes to investing, I scrutinise every decision and think of two reasons why I would and two reasons why I wouldn't buy a company's stock. Investments are the most important transactions you'll ever make, so know what you're buying and why you're buying it, and don't be fooled into doing otherwise, your future depends on it.
