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Warren Buffett is one of the most successful investors in the world, so when he gives advice, it often pays to listen. However, not all of his advice is suitable for every investor, and some of his tips can be risky for certain individuals.
While everyone’s situation is different, there’s one piece of advice from Warren Buffett that you may be better off ignoring.
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Should you diversify your portfolio?
Diversification is the process of buying a wide variety of stocks from multiple industries to limit your risk. If one or two of your stocks don’t perform well, you still have a solid safety net of healthy stocks to protect your portfolio.
In a 1996 Berkshire Hathaway shareholders meeting, though, Buffett famously claimed that “diversification is a protection against ignorance” and that it “makes very little sense for anyone that knows what they’re doing.”
The logic behind this advice is that there are relatively few wildly successful companies. Rather than spreading your money across 20 to 30 (mostly average) stocks, Buffett suggests putting as much as possible toward a very small number of stocks with the most potential for growth.
The risks behind this approach
While this strategy makes sense in theory, it’s not the right move for everyone — and there are a few important risks to consider.
It requires an enormous amount of research: If you’re going all-in on just a few stocks, you’ll need to be certain those stocks pay off. This will often involve hours and hours of heavy research to make sure you’re investing in the right places.
There’s little to no room for error: Extremely wealthy investors can often afford to take more risks. After all, one bad investment is unlikely to bankrupt someone like Buffett. But when your retirement is on the line, even a small mistake could wreak havoc on your financial future.
Stocks can sometimes be unpredictable: If everyone knew which companies would become the next Amazon, there would be many more billionaire investors. But even the most promising stocks can take unexpected turns, and there’s no way to know with 100% certainty which investments will see long-term growth.
Even if you do everything right, there’s always a chance that a stock may not pay off. And if you’re putting all your money behind only a few stocks, that is a lot of risk.
How diversification can keep your money safer
When you spread your money across a wide range of stocks, you can still earn substantial returns without as much risk. Now, it’s still important to choose your investments wisely because the more successful stocks you own, the more you can earn. But you also have more wiggle room since one or two flops won’t necessarily sink your entire portfolio.
It is possible to over-diversify, though. When you own too many stocks, your risk is significantly lower, but you’re also limiting your potential earnings. While there’s no hard number for how many you should own, a general guideline is to have roughly 20 to 30 stocks from various industries in your portfolio.
There’s no one-size-fits-all strategy for investing, but it is important to find the right strategy for you. While some investors will benefit from Buffett’s “less is more” approach, a well-diversified portfolio is a much safer option for most people.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Katie Brockman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon and Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.
