AAII Journal > April 2008
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The Role of Diversification in an Individual Stock Portfolio

by Vitaliy N. Katsenelson

It is frequently said that diversification is the only free lunch an investor will ever get, as this risk-reduction strategy doesn’t need to lead to subsequent reduction in return. Or does it?

Warren Buffett disagrees: "Diversification is a protection against ignorance. It makes little sense for those who know what they are doing."

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About the author

Vitaliy N. Katsenelson , CFA, is a portfolio manager with Investment Management Associates, based in Denver, Colorado. He is also author of “Active Value Investing: Making Money in Range-Bound Markets” and he maintains a Web site at www.activevalueinvesting.com..
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For individual investors managing their own portfolio of individual stocks, both statements are correct.

In one extreme, stock investors often fail to diversify, holding just a handful of companies and subjecting themselves to unnecessary risk.

However, what a finance book will not tell you is that a portfolio consisting of just a handful of stocks also enormously impairs your ability to make rational decisions at the time when that ability is needed the most—under pressure. Managing this emotional reality is one of the more subjective aspects of risk management through diversification.

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→ Vitaliy N. Katsenelson , CFA, is a portfolio manager with Investment Management Associates, based in Denver, Colorado. He is also author of “Active Value Investing: Making Money in Range-Bound Markets” and he maintains a Web site at www.activevalueinvesting.com. .

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