The Role of Diversification in an Individual Stock Portfolio
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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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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