Investing

The investing advice Warren Buffett recommends you follow, even though he doesn't

"Diversification is protection against ignorance," Buffett famously says.

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Warren Buffett
Gerald Miller | CNBC

Even though his portfolio results speak for themselves, Warren Buffett keeps dispensing sensible, tried-and-true investment wisdom to his followers, who over the years have learned to invest in American economic growth, buy stocks at attractive valuations, hold investments for the long term, and keep costs low.

Indeed, much of the traditional advice that investors receive comes straight from Buffett's playbook, with a notable exception: diversification. "Diversification is protection against ignorance," Buffett famously says. "It makes little sense if you know what you're doing."

Buffett built his fortune by taking concentrated positions in stocks he was most confident in, but investors who read that quote and think they ought to follow his lead are missing a major point: He does not think you know what you're doing — unless you devote your professional life to researching investments. Buffett calls nonprofessionals "know-nothing" investors, which isn't meant as a dig. "I'm a know-nothing dentist," Buffett once pointed out.

Instead, he posits that it's not smart to take big risks to get ahead in a game dominated by people who devote their lives to making money in markets.

When it comes to your portfolio, then, the message from Buffett and less-venerable investing experts alike is clear: Do as he says and not as he does. Here's why.

Why most investors may benefit from diversification

The idea behind building a well-diversified portfolio comes down to the concept of not wanting to put all of your eggs into one proverbial basket. "We often see on a year-by-year basis that the asset classes that are the best and worst performers tend to move around a lot," says Amy Arnott, a portfolio strategist at Morningstar. Diversifying can help you avoid overexposure to an area that's suddenly out of favor. "It can help reduce your portfolio's volatility to be invested in assets that are uncorrelated or that have relatively low correlation."

In other words, by buying in a mix of investments that tend to perform differently at different times, you reduce the odds that any one poorly performing investment is going to drag your overall portfolio down.

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That strategy is important for two reasons. For one, it helps keep your emotions at bay. Big drawdowns in your portfolio aren't necessarily a big deal if you have decades to invest so you can hold on and wait for a potential rebound. By reducing the amount your portfolio stands to lose during market pullbacks, you make it less likely that you're going to panic and sell when you see big red numbers on your brokerage screen.

And by spreading your risk across the portfolio, you can generally expect to achieve better, more stable returns over the long run, says Lauren Hunt, a certified financial planner and senior advisor at Moneta Group. "Building a portfolio where nothing moves in the exact same direction will give you a blended return," she says. "Research has shown that those portfolios will get you a higher risk-adjusted return over time."

In short, diversifying means you maximize your returns relative to the risk you take as an investor.

How to diversify: The basics

If you're a beginner investor, there's no need to try to spread your portfolio thin across dozens of investments, says Arnott: "If you're just starting out, you can feel good with a diversified U.S. stock fund and a diversified international stock fund."

By choosing funds that cover huge swaths of the global stock market, you ensure that you have exposure to companies of different sizes in different businesses across different geographies. A "total stock market" fund will give you exposure to several thousand of the largest stocks in the U.S. and a "total international stock" fund will have you investing in foreign businesses.

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Depending on your tolerance for risk and how close you are to retirement, the other base to consider covering is adding bonds to your portfolio. Over the long term, bonds will typically offer a lower return than stocks but for much less risk. If having an all-stock portfolio will keep you tossing and turning at night, or if you're close to retirement and can't financially withstand a shock to your portfolio, a greater allocation to bonds could help you preserve your wealth if stocks tank.

One easy way to solve the bond question, says Arnott, is investing in a target-date fund, which will hold a diversified mix of stocks and bonds that will grow more conservative (read: more heavily invested in bonds) as you near retirement age. "With a target-date fund you're getting built-in diversification, with exposure to most major asset classes and an asset mix that changes over time," says Arnott. "It's a great way to get diversification in one package without having to worry about building a portfolio with 10 different funds."

Other ways to diversify to optimize your portfolio

As you become a more sophisticated investor, you may want to take an active approach to spreading your bets across various asset classes. Investing pros recommend focusing on a few key factors.

Market size

Stock indexes, and the funds that track their performance, are typically weighted by market capitalization (colloquially, market "cap") found by multiplying a stock's share price by total shares outstanding. Large-cap companies, loosely defined as those with market caps over $10 billion, make up the bulk of major indexes, followed by mid caps ($2 billion to $10 billion) and small caps ($2 billion and under).

An investment in an S&P 500 fund comes with a 15% exposure to mid caps, with the rest in larger companies, while a total stock index might allocate 20% to mid caps and 8% to small caps. Aggressive investors may want to up those exposures, says Hunt. "Mid-cap and small-cap stocks tend to outperform large caps over the longer term," she says. "They're also going to have higher volatility. Portfolios that tilt toward large caps will tend to offer more stability."

Growth versus value

Stocks can be divvied up by the investing style of the people who favor them. Growth investors favor companies that are rapidly boosting earnings and reinvesting in their businesses. The results, ideally, are stock prices that outpace the growth of the broad stock market. Value investors hunt for stocks that trade cheaply compared to fundamental corporate measures such as earnings or revenues.

"The two styles will heavily ebb and flow in terms of what is in and out of favor," says Hunt. "Growth style heavily outweighed value in 2020. So far in 2021 it's been the opposite."

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Most broad market index funds will hold some of both, so no need to go out of your way to add a mix of growth and value funds to your portfolio if you'd rather just stick with a simple index strategy, says Arnott. But beefing up your allocation to value stocks can make sense for investors who are making big bets on some prominent growth names, such as, say, market-leading tech stocks.

"If you have a fairly large position in a growth-oriented stock, you can buy a value fund to try and offset some of that risk," she says. "You can also do it to take a contrarian approach. If you see that value stocks have fallen heavily out of favor, maybe you take a small tilt toward value in your portfolio."

The 'core and satellite' approach

Having a diversified portfolio doesn't mean that you're not allowed to like or bet on any one particular investment. But if you're saving for an important long-term goal, such as retirement, you want the bulk of your money in a portfolio that limits the risk that something catastrophic happens. "You're trying to build an all-weather portfolio," says Hunt. "Having something you can stick with through thick and thin is going to be the most important thing for an investor."

That's why, for hands-on investors, many advisors recommend a strategy they call "core and explore" or "core and satellite." The idea is to build your sensible, well-diversified portfolio with the vast majority or "core" of your assets and then build a smaller portfolio to branch out.

The direction you branch into is up to you. Some investors seek to diversify further by adding so-called alternative investments — ones that fall outside of the broad categories of stocks, bonds, and cash, and that offer a vast array of return profiles that can differ greatly from returns of the stock and bond markets. These can include complex, managed products such as private equity or hedge funds or straightforward investments in gold, commodities, collectibles, or real estate.

"These should be looked at as small pieces to add on the margins of your portfolio," says Arnott.

Similarly, investors can use their satellite to add positions in stocks they're interested in or even riskier assets such as cryptocurrency. What you invest in, and what portfolio sizing you choose, will depend on your tolerance for risk. But in general, Arnott recommends keeping riskier components to a small percent of your assets.

"If you have a small portion you want to keep to the side as play money, just make sure you're conscious of how much you can afford to lose," she says. "You should not be putting all of your retirement assets into individual stocks."

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