How Much Diversification is Enough?

Diversification is a word that has been getting thrown around a lot lately. “Don’t put all of your eggs in one basket”. I’m sure we’ve all heard that expression before. Diversification has been preached as a way to hedge your investments and lower your risk.

Many investors are extremely fearful of losing money from another market crash. So they diversify as much as they can. But how much diversification is enough? Can you diversify too much? Is diversification even necessary? Let me try to answer all of these as simply as I can.

How Much Should You Diversify?

This is a difficult question to answer, because it depends. It depends on a lot of different factors. Your financial status, risk tolerance, income level, investment knowledge, experience, and many other factors all play a role in answering this question. Since the answer will vary substantially from person to person, let me explain my view on diversification in general.

My investment philosophy follows similar principles to Warren Buffett’s investment strategy. To quote Buffett directly, he has stated that “diversification is protection against ignorance. It makes little sense if you know what you are doing.” I could not agree more with this statement. You shouldn’t diversify if you don’t know anything about those other investments. Invest in what you know.

If you don’t know anything about a new tech company, why would you invest in them? How will you know if they are running their business correctly? Are you just going to listen to Uncle Bob, who told you that this stock is going to triple overnight? That sounds like an extremely risky investment strategy, if you ask me.

Don’t get me wrong, I believe that diversification can be good. It can be good for those who don’t know what they’re doing when it comes to investing. Don’t risk all of your money by investing it all in one property or one stock.

Conclusion

If you don’t know what you’re doing, I recommend having a good amount of diversification. A mix of stocks, bonds, and alternative investments (real estate, private equity, etc.) is the usual route. It’s also important to invest in different industries and geographical areas. Or, work with an expert and leverage their investment knowledge and experience.

If you know what you’re doing, though, shouldn’t you focus most (if not all) of your attention on that? If you know all about the restaurant industry, why risk investing your money in another industry that you know almost nothing about? That doesn’t lower your risk, it increases it.

It’s important to be familiar with your individual situation. Be honest with yourself and decide which route is better for you.