How to Properly Diversify Your Investment Portfolio

Diversification is the only free lunch in investing, according to Nobel Prize-winning economist Harry Markowitz. But like most things in investing, the devil is in the details. Too little diversification exposes you to catastrophic single-stock risk. Too much diversification dilutes your returns to mediocrity. Finding the right balance is essential.

Warren Buffett has a famously nuanced position on diversification. He has called it "protection against ignorance" and argued that investors who truly understand their holdings need very little of it. Berkshire Hathaway's equity portfolio is highly concentrated, with Apple alone representing over 40% at times. But Buffett is also clear that this concentrated approach is only appropriate for investors who can dedicate the time and skill to deeply understand each holding. For everyone else, he recommends broad index funds -- which is maximum diversification.

Charlie Munger goes further: "Wide diversification is only required when investors do not understand what they are doing." Munger's own portfolio has typically held fewer than 10 stocks. His argument is that if you have genuine insight into a business, adding your 20th or 30th stock only dilutes the impact of your best ideas. Your best idea deserves more capital than your 30th-best idea.

However, Benjamin Graham provided the counterbalance that most investors need. He recommended holding 10-30 stocks across different industries. His reasoning was practical: even skilled analysts make mistakes, and no one can predict every company-specific disaster. Diversification across 10-30 carefully selected stocks eliminates most company-specific risk while allowing individual stock selection to add value.

The academic research supports Graham's range. Studies show that approximately 90% of diversifiable risk is eliminated with 15-20 stocks, and virtually all diversifiable risk is eliminated with 30 stocks. Beyond 30, additional stocks provide negligible risk reduction while diluting returns. The optimal number for most investors is 15-25 stocks across different sectors and geographies.

Howard Marks distinguishes between diversification across and diversification within. Diversifying across asset classes (stocks, bonds, real estate, international) provides protection against systemic risks that affect entire markets. Diversifying within each asset class (multiple stocks within equities) provides protection against company-specific risks. Both types are necessary for a truly robust portfolio.

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The Bottom Line

True diversification means owning assets that do not all move in the same direction at the same time. If everything in your portfolio goes up together, it will also go down together.