The Enron scandal didn't just hurt investors and the overall economy, it also affected the value of employee investment portfolios. Executives of the ill-fated energy company cooked the books, hiding losses and debt using a variety of accounting techniques. As all this was going on, many employees were encouraged to invest their entire portfolios in the company's stock. When the company fell in 2002, their savings were eradicated overnight.

This is one example of why diversification is widely considered an investing basic. Personal finance courses teach it as gospel, deriding individual stocks as tantamount to casino gambling. Billionaire investor Warren Buffett famously stated that "diversification is protection against ignorance. It makes little sense if you know what you are doing." In his view, studying one or two industries in great depth, learning their ins and outs, and using that knowledge to profit on those industries is more lucrative than spreading a portfolio across a broad array of sectors so that gains from certain sectors offset losses from others. In this article, we look at the concept of diversification and explore what Buffett meant by his quote.

Key Takeaways

  • Diversification is an investment strategy that prescribes investing in a series of asset classes, companies, and sectors.
  • An investor who diversifies their holdings can minimize their losses and risk.
  • Diversification doesn't work if you don't understand the basics of investing, so it's important to do your homework before you invest.

What Is Diversification?

Don't put all your eggs in one basket. That's the basic premise behind diversification. It is a popular investment strategy that tries to mitigate losses by spreading an investor's risk across multiple investments and different vehicles.

Here's how it works. Investors and financial professionals diversify their holdings by investing money in a variety of different investments. This gives them a cushion against risk. The idea behind this is that the positive gains generated by one investment effectively balance out any losses generated by another investment. You can do this by diversifying your stock holdings to companies in different sectors. You can further diversify your investment holdings—and neutralize stock market risk—by investing in fixed income securities, real estate, and cash.

Traders further diversify by selecting investments such as mutual funds and exchange-traded funds (ETFs) from different sectors that follow different trends. Another way they expand their holdings is to look beyond their borders. This means investing in foreign as well as domestic markets. Some investors follow the ups and downs of the broader market, while others remain relatively flat. Still, others move inversely with the broader market, experiencing ups when most sectors are down and vice versa. The idea behind this strategy is that no matter what the market is doing, a portion of the investor's portfolio is likely to do well.

Don't just invest in one asset class, but if you do invest only in stocks, consider companies that give you exposure to multiple sectors.

So the lesson is simple. The need for diversification is a portfolio theory rooted in the idea that an investor who puts all his or her money in one company or one industry flirts with disaster if that company or industry takes a nosedive.

Knowledge Is Power

The problem with diversification, in Buffett's view and investors just like him, is although the risk is managed and mitigated by sector gains offsetting sector losses, the opposite is also true. Sector losses offset sector gains and reduce returns.

Here's where the second part of that quote comes into play—that part about just how important it is to know what you're doing. This is something he can speak to with very good authority. That's because Buffett amassed a fortune by acquiring incalculable knowledge about all things finance and about specific companies and industries. He took that knowledge and hand-picked his investments. Just take a look at Berkshire Hathaway (BRK.A, BRK.B). The company is invested in many industries including railways, banks and financial companies, consumer goods, retail, food and beverages, and technology.

Few investors have been better at picking stocks and timing both entry and exit points than Buffett. An ignorant investor—someone with little to no financial or industry knowledge—is bound to make blunder after blunder if they try to play the market the same way Buffett does.

An investor who studies trends and has a keen understanding of how different companies and industries react to various market trends profits much more by using that knowledge to their advantage rather than passively investing across a wide range of companies and sectors. This kind of investor can go long on a company or sector when market conditions support a price increase and exit their long position by going short when indicators project a fall. By doing so, the investor can profit in either scenario. These profits, therefore, are not offset by losses in unrelated industries.

The Bottom Line

There's no doubt that it pays to be diversified. Doing so helps manage risk and mitigate losses. As one sector or investment class goes down, these losses should be neutralized by the gains in another. But, as Warren Buffett points out in his famous quote, you won't benefit from this strategy—or any other one, for that matter—if you don't know what you're doing. Knowledge is power, after all. Doing your homework before you begin actively investing will help you realize the returns you seek.