These would include growth stocks versus dividend paying stocks, small stocks versus large stocks, etc. Once again, the investor is faced with the issue of how much should be in growth, how much should be in value, how much should be in large, how much of the small, and on and on. I don't believe there is a general answer. The right answer is the answer that best fits the individual's needs and goals.
And the same concept would apply to investing in bonds. A prudent bond investor might want to ladder their portfolio over various maturities. How much they would allocate to longer maturities versus how much they would allocate to shorter maturities would depend on their belief as to where interest rates might be headed in conjunction with where they feel they are today. If the investor feels that rates are very low they would want to rely more on shorter maturities so that their money would mature into higher interest rates, if they believe rates were going higher. Conversely, if they feel that interest rates are very high they would want to orient their portfolio to the longest maturities possible in order to lock in the higher rates for as long as they possibly could. These considerations would have a major impact on their overall diversification strategy.
There is another argument that the Buffets and Mungers of the world offer against broad diversification. These investors who favor a more concentrated approach believe in essentially two things. First, they believe that extraordinary above-average investments are rare. They further argue that every investment you add would be, or should be, of lesser opportunity than your best choice is. In other words, your best stock will generate a higher return than your second best and so on. Their second belief is that you can only truly know enough about a very select number of companies to be able to invest wisely. Therefore, the more companies you include in your portfolio, the more diluted your knowledge about each will be. In other words they believe in placing all their eggs in one basket (or at least a very few baskets) and then watch that basket very carefully.
Diversification For Maximum Return Or Minimum Risk
As I've previously alluded, diversification is most commonly thought of as a way to reduce risk. However, the opposite side of the diversification coin is rate of return. Diversification, or the lack thereof, will have or should have a large and direct impact on the ultimate return that a portfolio will generate. However, the precise impact is once again a matter of debate. For example, in theory, the more fixed income a portfolio contains the lower the rate of return it would be expected to generate. In his best-selling book Beating the Street, Peter Lynch offered up this 26th Rule of his 25 Golden Rules of Investing (yes, it was his 26th of 25):
"in the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money market account. In the long run, a portfolio of poorly chosen stocks won't outperform the money left under the mattress."
Or you might prefer Peter's principle number two:
"gentlemen who prefer bonds don't know what they are missing."
Perhaps the moral of this story is that diversification has its pluses, but also has its minuses. While it can protect against risk and even smooth out long-term returns; it accomplishes all this at a cost. The seminal question is whether or not you, the individual investor, is willing or even capable of paying the price? Or put another way, how much rate of return are you willing to give up, to buy how much peace of mind? Again, I see this as an individual decision, and perhaps even more importantly, a function of the amount of knowledge you the individual investor possesses and the amount of volatility risk you can endure. Clearly, most of us are not Charlie Munger or Warren Buffett that can afford the luxury of a highly concentrated portfolio. On the other hand, we don't want to be guilty of "di-worse-ification" either. At the end of the day, finding the right balance is as much a personal thing as it is an ironclad principle. At least it is in my way of thinking.
A Fun Look at Diversification Within the Asset Class Equity (stocks)
As I went through the process of researching diversification I came across some interesting results that frankly astounded me. Therefore, I thought it would be fun to share what I discovered. First of all, the primary goal of my research was an attempt to ascertain how much diversification within an asset class was the appropriate amount. Stated more simply, how many stocks were enough to protect the money and how many stocks were too much to dilute or destroy returns. Although I didn't come up with a precise answer that satisfied me, I did discover some fascinating numbers.
Utilizing the F.A.S.T. Graphs research tool I ran 20-year track records on several well-known indices that contained a low of 30 stocks all the way up to 5000 stocks. Before I ran these various records, I assumed that the indicie with the least number of companies would produce the highest rates of return and vice versa.
30 Dow Jones Industrials' 20-year Record
My first example is the DJIA, because it is a diversified portfolio but only contains 30 names. As expected, the 30 Dow Jones Industrials did produce the highest rate of return at 7.3% per annum.
The S&P 500 Without Dividends
My second example is the S&P 500. Since the index contains 500 companies, I expected to see a lower annual rate of return due to the much broader diversification. Even though I was correct, the return differential was only 1.2% per annum coming in at 6.1%. From the standpoint of risk, you could say that you didn't give up much return for the greater safety.
Since this article is all about diversification, I have included the sector breakdown of the S&P 500 in order to illustrate the diversification within this broad index.