Enter Warren Buffett, or at least a 15-year younger version of him. In his 1993 letter to shareholders, Buffett wrote
“[A] situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.
“On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”
You might think that by Buffett’s definition, the investing world is divided into 50% “know-something” investors and 50% “know-nothing” investors, but this isn’t right. Because of the cost of commissions, spreads, increased volatility, increased capital gains taxes, and losses due to market timing attempts, the proportion of investors who beat the index is way below 50%. So, there’s a good chance that you and I are both “know-nothing” investors by Buffett’s definition.
The good news is that even if you can’t evaluate the prospects of individual businesses effectively enough to beat the index, you can still beat most other investors by buying the index.