Warren Buffett once said that he believed the three most important words in investing are "margin of safety." This concept comes through in different ways. Often, it means buying shares of stock at attractive prices so that an investor may make a profit even if the future turns out much less rosier than initially predicted. Benjamin Graham, the author of The Intelligent Investor, extended the margin of safety concept to his understanding of diversification as well.
Here's what the famed Columbia professor and mentor to Warren Buffett had to say about portfolio diversification:
"There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor's favor, an individual security may work out badly. For the margin guarantees only that he has a higher chance of profit than loss-not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance underwriting basis.
Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion. This point may be made more colorful by a reference to the arithmetic of roulette. If a man bets a $1 on a single number, he is paid $35 profit when he wins-but the odds are 37 to 1 that he will lose. He has a negative 'margin of safety.' In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets a $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. But suppose the winner received $39 instead of $35. Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers."
This is the source of my confidence as an investor-the place where high-quality blue-chip companies meet a diversified portfolio. I am very interested in creating a margin of safety that builds on itself. And I believe the best way to do this is by identifying a list of the highest quality companies, and then slowly but surely, adding to them one by one when the price is right. The first year of building a portfolio might involve buying General Electric (GE) at $18 and Johnson & Johnson (JNJ) at $62. The next year might involve buying Microsoft (MSFT) at $30 and Conoco Phillips (COP) at $51. A decade of following this strategy could create a portfolio built to withstand whatever chaotic operating environment the world throws it.
The Graham explanation of diversification does not guarantee a strategy to maximize returns, but rather, to increase the certainty of gain. Maybe holding a portfolio that consists of IBM (IBM) and Walgreen (WAG) will generate the highest returns over the coming decade. But the certainty of a profit increases when the portfolio also includes Coke (KO), Colgate-Palmolive (CL), Emerson Electric (EMR), Exxon Mobil (XOM), and Berkshire Hathaway (BRK.B). This works as long as you are identifying companies of similar earnings quality to benefit from diversification's increased certainty of gain principle.
When I think about the margin of safety concept in relation to diversification, I am reminded of Buffett's dictum that "rule number one is to never lose money." I would apply that wisdom in my own portfolio by going to great lengths to reduce the likelihood of permanent capital impairment. If I have a $400,000 portfolio of four stocks and one goes bankrupt, I did not merely lose $100,000. I also lost a lifetime of compounding that the $100,000 loss could have created throughout the rest of my investing career. If I take that $400,000 portfolio and divide it into twenty $20,000 investments of the strongest companies that I can find, then I can recover from permanent capital impairment much more easily-I wouldn't have to worry about a Lehman Brothers, Wachovia, or Eastman Kodak single-handedly derailing my investment plan.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.