Detect accounting fraud, invest safely.

Anurag Gupta, an average Joe retail investor, buys 150 stocks and he’s the poster child of diversification. Who’s Anurag? Doesn’t matter. What’s important is he managed to beat the broad market. That’s something. Or is it?

Well, according to the article, Anurag started investing six years ago. That takes us back to 2002 roughly after the dot-com bust and the Enron scandal when the broad market is almost at its bottom. Since then the market had rallied until the end of 2007. In a market rally, even I can look like a genius. But as Buffett said, “You only find out who’s been swimming naked when the tide goes out.” Question is, will Anurag still outperform the market in the next five years? Six years seem like too short a time to measure a track record of any investor. But let’s give Anurag the benefit of the doubt.

We’ve all heard of the adage “Don’t put all your eggs in one basket.” Diversification is wonderful for those who don’t know much about what they own. The reasoning is simple: if you don’t know which card is the Queen in a three-card monte, you bet on all three. (Of course, as in all gambling, the winnings never cover the losses. In this case, you still end up losing one bet.) Diversification is the basis for a stock index, the perfect investment vehicle for those who would like to diversify and have no interest in learning about what they own.

Mark Dowie has beaten the topic of investing in index funds to death for the uninitiated individual investors. This was Google’s pre-IPO response to help their newly minted millionaire employees preserve their wealth. Most people are not capable of beating the market. Buffett has always dispensed the same advice to those who don’t know much about investing.

Nonetheless, diversification, like many things in nature, has a point of diminishing returns. The exact point has been well debated and yet no one knows for sure. “20″ has been the most commonly recommended number of stocks in a portfolio to achieve sufficient diversification. Some has recommended “12″. Beyond that the cost of analyzing and selecting the next stock is not worth the incremental diversification gain.

But the moment we start preaching diversification to a different group of investors such as gifted stock pickers, we are scorned almost to the point of abomination. Even Buffett and Munger take on a 180-degree view on diversification when it comes to stock picking. In fact, both Buffett and Munger pull no punches on the absurdity of diversification for the know-something investors. One of Buffett’s most famous quotes from the 1996 Berkshire Annual Meeting is “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”

In the 2004 Berkshire Annual Meeting, Munger, with his usual blunt criticisms, had this to say about diversification, “The idea of excessive diversification is madness.”

“If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.” said Buffett, in the recent 2008 Berkshire Annual Meeting.

In a recent article Is It Time to Tiptoe Into Financial Stocks?, Jason Zweig wrote

If you are still tempted to bottom-fish for financial flounder, at least diversify. Consider Vanguard Financials or iShares Dow Jones U.S. Financial Sector.

In response to Jason Zweig, the eloquent investor-blogger, Geoff Gannon, wrote:

You are to do no such thing. If you’re going to buy financials, don’t buy them indiscriminately above book value. You need a margin of safety – and you can’t diversify your way to safety.

Notice a trend?

When you decide to join the group of investors who pick their own stocks, like it or not, you have left the camp of investors who expect nothing more than market returns. Have you heard of anyone invested in an index fund beat the market? The only reason you choose to join the stock picking camp is you find market returns unacceptable. You demand market beating returns. And most important of all, you think you’ve got what it takes to beat the market.

If you believe you are a gifted stock picker, diversification will only dilute your performance. This bears reiteration - diversification never improves your performance. It may reduce volatility and limit your downside but it will never add to your upside. Now, I’m not saying diversification is pointless. But because it is less important than other factors considered in selecting a stock, it should perhaps be one of the last things to think about before investing in a stock.

Owning one stock in a portfolio is probably not a good idea unless you control the destiny of the company. As long as you know that you should own more than one stock in your portfolio, I think you will do fine with diversification. The trick though is to first find the next best stock to own regardless of what industry it is in. Never find a stock in a different industry just because you want to diversify. Take a look at Leucadia holdings. Five out of their seven holdings are in the financial sector. It only makes sense since there are more opportunities in the financial sector now. It’s the first place to look for bargains. I bet diversification never came across Ian Cumming’s and Joe Steinberg’s minds when they made these investments. Subconsciously, they knew they didn’t want to own a one-stock portfolio. But they didn’t plan on owning seven to achieve sufficient diversification. It just kinda happened. Sure, Leucadia in its own right is a diversified holding company. But that’s still a big chunk of money invested in financials.

The most crucial thing to remember is diversification must never be the sole reason you sell a stock. If you sold a stock because a position has grown too large, you are limiting yourself to the profits you are entitled to. This is the same reason most diversified mutual funds often underperform the market. The rules surrounding a diversified mutual fund prohibit a position from occupying more than 25% of a portfolio. If a fund manager bought a stock that makes up 20% of the fund holdings, the fund is then limited to a 25% gain on that investment assuming the fund assets remain unchanged. So if the fund manager was confident that a position would result in a 100% gain, he would have to trim the investment down to 12.5% of the portfolio just so he complies with the diversification rules. Alternatively, he could stick with the 20% position and just keep trimming the position as it reaches the 25% mark. That’s a lot of work and frictional costs just to maintain diversification.

I think Buffett’s letter to his Buffett Partnerhip shareholders in 1965 (PDF) pretty much sums it all. The point to remember is that diversification is good but not the silver bullet for successful investing. Can you imagine catching up on reading 150 annual reports? If you are going to buy that many stocks, you might as well buy the index. You are better diversified and you don’t have to bother picking the stocks either. Leave the picking to the index fund. Zecco’s zero-commission offer is a godsend. But don’t corrupt your investing principles for the sake of free trades. Think about how much time you are wasting picking stocks that won’t add to your performance anyway. Plus, you better have a damn good accountant to keep track of the dividends and capital gains for tax planning.

Anurag might have done better holding 15 stocks.