‘‘Diversification is a protection against ignorance. It makes little sense for those who know what they are doing,” says Buffett. However, there are others who think that diversification is like the closest thing to a free lunch an investor will ever get.



Both considerations are correct. On the one side, investors often fail to diversify and hold a group of companies and subject themselves to unnecessary risk. A portfolio consisting of just a handful of stocks also enormously impairs the 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. An example is related to Marsh & McLennan. There were many shareholders who invested all their wealth in the company. At first, when they made the investments they did not think the company would have any problem. However, all of a sudden, a lawsuit was filed against the company and the outcome was bankruptcy.



That is why it is advisable not to invest in only few companies. The risk of losing everything is higher.



At the other extreme, investors holding hundreds of stocks incur another cost — ignorance. This means that having many companies in a portfolio makes it impossible to know them deeply. Lack of knowledge leads to an inability to make rational decisions. Another side effect of diversification is indifference to individual investment decisions.



None of the extremes are good; therefore it is better to weigh the consequences of either of them.



Taking diversification a step further, stress testing a portfolio — playing out different what-if scenarios — for probable risks coming to fruition is critical. Once stress testing reveals exposure to a certain risk or event, there is enough information to realign the portfolio accordingly and unemotionally.



There is something, nonetheless, that has to be considered: the mental accounting trap. It is one of the most frequently visited potholes in investing, usually located somewhere near the value and relative valueproblems.



It is important to be diligent in the analysis, but it is more important to accept that one just will not be right all the time on every stock. Even if the analysis and the process taken are right on the money, there may occur unpredictable events that may turn what was supposed to be a good investment into a loss. Over time investors make mistakes — that is a reality of investing.



There is a reason for a diversified portfolio of stocks — to allow room for losers. When one makes mistakes, it is necessary to try to learn as much as possible from them and move on. If a mistake drives one crazy, the rest of the portfolio will suffer, as it will obscure judgment.



It is worth paying close attention to fundamentals and not be overly sensitive to individual short-term stock priceaction, as more often than not it is a manifestation of random noise. In general investors observe noises for two reasons: Returns from stocks are not normally distributed; thus the fluctuations are sharper. And second, individual stocks are more volatile than a portfolio of stocks. If focus is based on the performance of individual stocks on a short-term basis, rather than on the overall portfolio, even more short-term volatility (noise) will be observed.



In the short run, volatility of the portfolio and individual stocks is observed, but not the returns. It is paramount that investors don’t act on noise! They have to focus on the stock in the context of the total portfolio, and focus more on whether the company quality, valuation and growth story is still on track.



A properly diversified equity portfolio should consist of stocks from different industries, of various sizes, growth rates, valuations, and countries. At times the market will fancy a certain characteristic over another, which is what markets do and is at least in part why investors diversify: to lower overall volatility. Why is it in part? There are two reasons: first, and the most important, to limit exposure to the true risk—a permanent loss of capital; second, to be able to maintain a rational state of mind. As mentioned earlier, a portfolio should have a small enough number of stocks that every decision matters, but not so few that the cost of being wrong in a stock is unbearable. Investors should not make marginal decisions for the sake of diversification.



Randomness can work to one's advantage, as it may at times drive stocks owned above their intrinsic values, providing an opportunity to sell earlier than what was originally expected at the time of purchase. It may also drive totally fine stocks below their intrinsic values, providing an opportunity to buy more.



