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Warren Buffett says that you should be diversified, but not to “mediocrity”. To lower risk it is essential to split your fund between at least five companies and possibly as many as 20, or 25 if you are full-time professional investor. Beyond that you are diversifying outside of your best ideas, the true bargains. Also, it is very difficult to keep track of dozens of companies. You might end up with only superficial knowledge of each.
John Templeton would say that the only people who should not diversify are those who are right 100% of the time; few investors are right more than two-thirds of the time – he included himself in this assessment.
Templeton offered a guideline: every investor should have at least 10 shares. Even if you are extremely careful in your share selection you cannot predict the future. A major oil spill, an unexpected technological advance by a competitor or a government dictat can remove half the value from the company. In addition, you may not have spotted serious internal problems when you first undertook the analysis.
Thus you must diversify – by company, by industry, and by risk.
For the fund I’ll be running next year full-time (one open to small investors and institutions) I expect to diversify to at least 16 companies to avoid these Templeton dangers and to benefit from a wide range of great business models. But I’ll be surprised if the portfolio is split more than 25 ways – there just aren’t that many good ideas out there.
Be bottom-up
Buffett and Templeton are/were both bottom-up analysts, examining shares at a company level first. If that leads to a concentration in a particular country that year, then so be it.
This concentration may appear to
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