Concentration makes it easier to build wealth. Diversification helps you keep wealth once you have it.

But using concentration to build wealth quickly only works if you concentrate in the right areas. If you choose wrong, you’d be better off diversifying and buying more things since that makes it more likely you’ll make money somewhere even if you grow wealth more slowly. In this article, we’ll talk about when and why you should diversify in your investing and why it matters.

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The effects of diversification

Looking at the whole of the US economy, the growth rate is around 10% over long periods of time. Inflation tends to be around 3%, so the total return after inflation is around 7% annualized. This means that if you were to buy every stock in the US economy and hold for 10 or 15 years, your returns would likely be in the vicinity of 7% after inflation. This means that the amount your portfolio would have grown would be similar to the results if you could have bought a bank CD paying 10% per year.

This is not an exact return. During some 10-year periods, you might make 15% annualized. Others you might make 1 or 2%. If you hold longer, like 15 or 20 years, then the spread tightens and returns are likely to be between say 6% and 14%. The longer you hold, the tighter the range of returns gets. This all assumes that returns in the future are like those in the past, meaning the US economy continues to grow at the same rate. There is no guarantee that this will happen, but also no apparent reason that it will stop doing so.

Note that diversification makes your returns more predictable. If you were to buy one or two stocks and hold them for 10 or 20 years, your returns could be all over the map. If you chose well, you could have had a 20% or 30% annualized return. If you had chosen poorly, you could have had a very small return, no return, or even a negative return. One or both of the stocks could have gone bankrupt and you could have lost the whole position. The effects of diversification are to make your returns more predictable.

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How do you diversify?

While you can’t buy every stock in the US market, the more US stocks you buy of different types, the closer your returns will approach to buying every stock. In the past this required that you actually buy a lot of different stocks, which would require that you had a lot of money to invest. Today, mutual funds, especially index mutual funds and ETFs, make diversifying your money easy.

Buying a diversified mutual fund like an S&P500 fund or a small-cap index fund allows you to buy many stocks with a single purchase. Buying index funds or ETFs will keep your costs low, meaning your returns should approach those of the market. By doing this you’re making it likely that you’ll at least do as well as the markets do. With a historical return of 10%, this isn’t a bad idea.

There are many ETFs to choose from. You buy these on the open market using a broker just like you buy a stock. Some of the major ones are the DIA, known as the “Diamonds,” that invest in the Dow Jones Industrial Average stocks, the QQQ (“the Q’s”), that invest in the NASDAQ 100 index stocks, and the SPDR (“Spiders”), that invest in the S&P500. Many mutual fund companies, like Vanguard and Schwab, sell their own index funds and ETFs. A good small-cap fund is the Vanguard Small Cap ETF, symbol VB. VO is the symbol for a Vanguard mid-cap ETF.

Why not always diversify?

The downside of diversification is that you reduce your potential return because you have spread out your money. While the long-term return of a diversified large stock index is usually around 10%, a single stock can easy return 100% or more in a single year. Even a set of three stocks can return triple digit returns each year. If you want to grow your money quickly, picking one or two great stocks, buying a large position, and holding onto it as it grows is an effective way to do it.

Realize that most people who become wealthy (especially those who become very wealthy, into billionaire status) do so by starting and running a company and holding onto most of the equity in the company as it grows. In that case they have everything invested in one company. When that company becomes huge, they become very wealthy. Many times they never sell substantial amounts of stock, instead borrowing against their position to but things they want. You may not have the desire to start and run a company, but by concentrating your position, you can get the next best thing.

You might read the above and wonder why people would diversify if they could make far better returns by concentrating in one or a few stocks. The reason is that it is very difficult to pick which stocks will do well, especially over very short periods of time and very long periods of time. When you concentrate, you’ll beat the markets if the stocks you pick do well but will have much worse returns if the stocks you pick don’t do well compared to the average stock. But if you diversify, you’ll always have at least some of your money in whatever is doing well.

Many studies have been done and have shown that an index, where you’re buying a large number of stocks and diversifying, will do better than most money managers will do picking stocks. Many people figure that if the money managers can’t beat the index funds and diversification, why would they think they themselves could do so? As a result, people now are diversifying and just using index funds more and more.

If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)

When should you diversify?

Most of the time, diversification is a good idea. If you are investing in your retirement account, you want to reduce the risk that you won’t have the money you need for retirement. By starting to invest early and diversifying your investments, you make your returns positive and predictable. You have lots of time, so there is no reason to take on the risk of concentration, instead letting time grow your account balance in a fairly predictable way. Investing at 7% over several decades will allow you to put a modest amount away — less than your mortgage payment and maybe your car payment — and have plenty of money for retirement. Because of this, there is little reason to try to do better than the market returns. Instead, you invest in a diversified way, while minimizing your fees and costs, to try to get the market return of around 7% after inflation.

You should also diversify when you have accumulated wealth and want to hold onto it. Things happen to single stocks. There is also no guarantee that a single stock will come back from a big setback. Companies can and do fall and never return to old high prices. Eventually every company will go bankrupt or be bought out by another company and disappear. By buying many companies, those that fail do not destroy your portfolio. Other stocks take their place and grow. Because the economy is always growing, you’ll make positive returns over long periods of time.

A strategy to use concentration to grow wealth

So, a great strategy is to concentrate some of your investments in a taxable investment account. This is money beyond what you need for retirement and other essentials. Find a handful of great stocks and accumulate large positions – 500 to 1000 shares as a minimum. These should be companies who have a business that you believe in and that has lots of room to grow. Find companies that are trading in the $10 to $30 range so that you can accumulate a lot of shares without a huge amount of money. (To learn how to pick stocks, check out Investing to Win for stock picking strategies and criteria to find the kind of companies for long-term growth.)

Hold these stocks as long as you still believe in the companies. As they grow, trim your positions back and put the money into diversified mutual funds. When you are first starting out and you have less than ten thousand invested, say, you might set a limit of 40% of your net worth for any one position. If it grows beyond this, you sell 20% of your position and put it into an ETF. As your net worth grows, you cut the biggest positions you will allow before you trim and diversify back to 25%, 15%, 10%, and so on. When you have millions, around a 5% limit is good. This is still large enough to allow your winners to have an impact but the effect if you have one crash will not set you back very far.

This strategy will minimize your trading, reducing fees and taxes. It will also take your emotions out of the equation, preventing you from selling out through fear or buying at a top out of greed. It will also minimize taxes since you’ll have natural reinvestment as your positions grow. So, concentrate when you want to grow wealth, diversify when you want to keep it.

Don’t know how to invest? Check out The Smallivy Book of Investing for a great primer. It gives you all the information you need to start investing and managing your wealth.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing..