Diversification is the golden rule?

When it comes to investing, people often question whether they have enough diversification.

"Concentration to create wealth" and "Diversification to preserve wealth" is my usual response. I am not sure where I got those ideas from, but the following from Warren Buffett's letter to shareholders in 1991 is an excellent illustration on this topic.

If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products?

John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . . One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence."

The true question then becomes how strong is your willingness to create wealth, and do you understand the implications behind that. In addition, how do you know that your full confidence is not a sense of illusion. The principle of "Margin of Safety" is really the best discipline tool one can use (Simple example: buy asset for 50 cents when it is worth a dollar).

With a margin of safety, the probability of investment success is at a higher percentage but by no mean a guarantee. Just as someone who holds a pair of aces before the flop in a poker game does not guarantee him/her a winner of that round. But by being selective, over the long term, concentrating on good starting hands will eventually pay off more significantly than trying to pick the pots with many marginal hands.