"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."
This quote comes from Warren Buffett, who is famous for investing in a small number of stocks and holding them forever. As a strong advocate for tightly concentrated portfolios, Buffett believes that holding too many stocks can water down your returns. How many is too many? Well, he has argued that six wonderful businesses are all you need, adding that "very few people have gotten rich on their seventh-best idea."
He practices what he preaches. While Berkshire Hathaway has ownership interests in about 45 companies, the lion's share of the portfolio (nearly two-thirds) is invested in just six names. The biggest is Apple (Nasdaq: AAPL), followed by Wells Fargo (NYSE: WFC), Kraft Heinz (Nasdaq: KHC), Bank of America (NYSE: BAC), Coca-Cola (NYSE: KO), and American Express (NYSE: AXP).Buffett isn't afraid to make colossal investments in a small handful of positions. And with few exceptions, these big bets usually work out brilliantly. Of course, we're also talking about the most astute stock picker of all time. For those without his legendary skills, this strategy might be far less productive -- possibly even dangerous.
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Even Buffett Makes Mistakes
Until recently, Buffett's single largest position (488 million shares worth nearly $30 billion) was in Wells Fargo. You have probably seen the bank in the news lately -- for all the wrong reasons. Wells Fargo has been embroiled in an embarrassing scandal involving the creation of millions of fake, unauthorized customer accounts.
The backlash from these deceptive sales practices and weak corporate governance has been severe. Over 5,000 employees were given the ax, and the company has set aside more than $3 billion to cover anticipated fines and legal costs. Several board members were nearly ousted and kept their jobs only by the skin of their teeth.
Innocent shareholders have also been stung by the ongoing probes and sanctions. On February 5, outgoing Federal Reserve chief Janet Yellen imposed some harsh punishments, reprimanding the bank for "pervasive and persistent misconduct." WFC shares tumbled more than 7% that day, costing Berkshire Hathaway about $2.4 billion.
If even Warren Buffett (who is on a first-name basis with the CEO) couldn't see this wreck coming, then how can the average Joe be expected to steer clear? The hard truth is we usually can't. Unless you want to park all your money in safe bank CDs paying next to nothing, investing in equities sometimes involves unexpected setbacks.
A Punch In The Gut Could Be Waiting Right Around The Corner
This isn't really about Wells Fargo. The fact is, punishing stock declines of 20%, 30%, or more happen all the time, for a wide variety of reasons. Some can be seen a mile away, but others are abrupt and unavoidable.
That's why I advocate spreading your assets more judiciously among a larger number of holdings so one or two torpedoes won't sink your entire portfolio. With rare exceptions, I seldom advise putting more than 5% of your money in any one position.
Sure, I will invest more in certain high-confidence picks than others, but without going overboard. This might limit the impact from a triple-digit winner in my High-Yield Investing portfolio, such as CME Group (Nasdaq: CME), where we are showing a 156% gain at last count, but it will also soften the blow from a laggard.
Buffett can afford to take a $2.4 billion hit, but you and I must be more cautious.
Ironically, this safer approach can also yield better returns. Morningstar just conducted a fascinating study to analyze the correlation between portfolio size and returns. It analyzed thousands of mutual funds grouped only by the number of portfolio holdings, with no other variables, and then compared their performances.
Morningstar found that the most concentrated portfolios (between 1 and 29 stocks) generated the lowest five-year returns, while the most diversified (250 stocks or more) produced the highest returns. They were separated by 17 percentage points in terms of average percentile ranking.
Now, I'm not saying you need to call your broker and place buy orders for two hundred stocks tomorrow. Even fifty can be unwieldy and difficult to keep close tabs on. The point is this: be careful betting most of your chips on just one or two hands.
In my High-Yield Investing premium newsletter, I continue to hold about three dozen stocks and funds spanning a cross-section of industries, sizes, and geographic regions. That's close to a maximum for me. So with new prospects knocking on the door to get in, don't be surprised to see me cash out some gains here and there.
If you'd like to join us in our search for the best high yields the market has to offer, then I want to invite you to learn more about High-Yield Investing. You don't have to settle for the paltry yields offered by most stocks. The high yields are still out there. You just have to know where to look -- and my staff and I are here to help you along.
Some of our picks might surprise you. For example, we have one holding that's been in the portfolio for -- get this -- nearly 13 years. A stable energy pipeline business, it's rewarded my subscribers and I with a gain of 429%. And thanks to steadily increasing dividends over the years, we now earn a 20.7% yield on what we originally paid for the stock.
If you'd like to see how High-Yield Investing can help you pull in double-digit yields like this -- and some impressive capital gains to boot -- go here to read this report.
This article originally appeared on StreetAuthority.com.