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Why diversification matters

Robert G. Hagstrom’s The Warren Buffett Way stresses the point that Warren Buffett and right-hand man Charlie Munger will only invest in industries that they truly understand – and only in companies that he believes possess a convincing margin of safety with outstanding long-term potential. He claims that owning a large number of companies spread over many industries is not as important as owning four or five companies that you know the ins and outs of.

Meanwhile, investors and fund managers stress the importance of maintaining a diversified portfolio, which spreads the risk not only over many industries, but also internationally.

Time and trends have shown us that diversification is, in fact, a necessity. Look no further than the dot-com bubble. Investors world-wide grew convinced that virtually any company with a “.com” at the end of its name would become the next best thing. That boom lasted only for a short period of time. Few dot-com companies, if any, came out unscathed after the bubble burst. Even market heavyweights such as Amazon.com (NASDAQ: AMZN) shed around 90% of their market value in the crash. The investors who focused solely on this industry experienced immense losses as a result.

In more recent economic news, it seems Australia’s mining boom is on its decline. Investors who were first to recognise the potential of mining companies reaped the benefits of their early purchases in mining blue-chips Rio Tinto (ASX: RIO) or BHP Billiton (ASX: BHP), or even one of The Motley Fool’s early favorites, Maverick Drilling and Exploration Limited (ASX: MAD), which rose 645% within about six months. Again, investors with little diversification in their portfolios have felt the pinch of the declining industry since.

Buffett, over his decades of investing, has managed to avoid most of Mr. Market’s mood swings that were caused by collapsing industries. This is because he did not see the long-term sustainability that many companies in these industries could possess and chose instead to invest in industries he felt would last for decades.

Foolish takeaway

Investors are wise to not put all of their eggs in one basket – that’s a given. As one company in a portfolio experiences a crack or a setback, the other elements of a well-selected portfolio will support that loss. Buffett’s point however, is that whilst diversification is a necessity, an investor should also learn about the companies they invest in. They should put their money into a few companies that they know well, with the ability to trust that the core foundations of those businesses will be enough to ensure a strong and sustainable future, and strong growth for the investor.

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More reading

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool writer/analyst Ryan Newman does not own shares in any of the companies mentioned in this article.

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