Warren Buffett has many well known investing quotes but one that might surprise readers is: "Diversification is protection against ignorance. It makes little sense if you know what you are doing."
This statement appears to go totally against the accepted concept that an investor who puts all of his or her capital in one company or one industry is flirting with disaster if that company or industry goes through a downturn.
More recently however, Buffett explained that: "If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it's not your game, participate in total diversification."
What he is basically saying here is that professional investors, such as fund managers, should be focusing most of their capital into a small number of high-conviction investments that they are able to extensively research and are confident in their long-term prospects.
Indeed, Buffett has consistently avoided diversification when investing at Berkshire Hathaway. Instead, he has made big bets on a few companies like Coca-Cola and American Express and an academic study has shown that over the period from 1976 to 2006, Berkshire Hathaway's portfolio was concentrated in relatively few stocks, with the top five holdings averaging 73 percent of the portfolio value.
Buffett goes on to say: "The goal of a non-professional should not be to pick winners – neither he nor his helpers can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well."
With most self-managed superannuation fund (SMSF) investors lacking the skill, time and resources to research and analyse companies in depth, it would therefore be wise to have a diversified portfolio.
This can be done in a number of ways and three easy ways to achieve this include:
Using Exchange Traded Funds
Exchange traded funds (ETFs) provide investors the benefit of instant diversification without the high price tag usually associated with managed funds.
ETFs trade on the share market exactly like shares, giving investors the ability to diversify across an asset class in one easy transaction. The underlying securities typically track an index, such as a market index or an index that investment experts have constructed to provide investors with a specific investment outcome.
ETFs are also available for assets such as international shares, fixed income products, foreign currencies, precious metals and commodities.
Invest in International Markets
The S&P/ASX 200 (Index:^AXJO) (ASX:XJO) has underperformed global markets over recent years due to the high weighting of energy and resources companies that make up the index. In addition to this, the Australian market is significantly underweight in high-growth industries such as information technology.
Importantly, it is becoming more accessible for Australian investors to purchase global shares directly through a number of online brokers as well as through ETFs.
Investors also have the option of investing with fund managers such as Magellan Financial Group Ltd (ASX: MFG) and Platinum Asset Management Limited (ASX: PTM). There are also a number of listed funds that are invested directly in international shares such as the Magellan Flagship Fund Limited (ASX: MFF).
Look for growth in Smaller Companies
SMSF investors tend to steer clear of smaller cap companies as they are usually associated with higher volatility and poor liquidity. Unfortunately, investors are also missing out on some of the best opportunities that exist in this sector of the market.
The best way to access this part of the market, I believe, is through a dedicated small cap fund manager. These managers are experts in this field and devote significant resources to research these companies.
Some small cap fund managers have performed extremely well over the past five years with the Ausbil Microcap Fund being a star performer – returning 24.6% per annum over the last five years. Other great performing funds include the BT Wholesale MicroCap Opportunities Fund and NovaPort Smaller Companies Fund, both of which have delivered double-digit returns over the past five years. These managers though will generally charge annual management fees, which will impact net returns.
Investors could also consider investing in Contango Microcap Ltd (ASX: CTN) which is listed on the ASX.
Foolish takeaway
Stock-picking isn't easy and many SMSF investors lack the time and resources to do this successfully. Instead, consider building your core portfolio with diversification in mind, and then invest in what you believe are the best individual opportunities available.
