Warren Buffett’s Thoughts on Diversifying Your Portfolio
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Although it’s common wisdom to own a portfolio of diversified stocks, in this article, we are going to be listening to Warren Buffett, one of the greatest investors of all time, describe why he recommends that serious and knowledgeable investors should ignore conventional wisdom and purposely have a concentrated portfolio of stocks.
All you have to do is just stick around to the end because you are going to hear and learn from this successful investor. You are also going to learn how to apply the concepts Warren Buffet lays out to your investment portfolio.
Without further ado, let's analyze Warren Buffett’s thoughts on diversification. He says - “The question is about diversification and I’ve got a dual answer to that. If you are not a professional investor, if your goal is not to manage money in such a way as to get a significantly better return in the world; then I believe in extreme diversification. I mean if so, I believe 98 or 99%, maybe more than 99% of people who invest should extensively diversify and not trade.
So that leads them to an index fund type of decision with very low cost because all they're going to do is own a part of America and they made a decision that only part of America is worthwhile. I don't quarrel with that at all, that is the way they should approach it unless they want to bring intensity to the game to make a decision and start evaluating businesses. But once you're in the business of evaluating businesses and you decide that you're going to bring the effort and intensity and time involved to get that job done, then I think the diversification is a terrible mistake. And to any degree, I got asked that question at SunTrust the other day and if you know businesses, you probably shouldn't own more than six of them. I mean if you can identify six wonderful businesses, that is all the diversification you need and you're gonna make a lot of money and I will guarantee you that going into a seventh one is going to rather than putting more money in your first one, it's got to be a terrible mistake. Very few people have gotten rich on their seventh best idea but a lot of people have gotten rich on their best idea.”
He continues his sentiments about taking big bets on a small set of opportunities. He says “Yeah, omissions are way bigger than commission. Bigger opportunities in life have to be seized. We don't do very many things but when we get the chance to do something that's right and big, we've got to do it. And even to do it on a small scale is just as big a mistake. It’s almost like not doing it at all. I mean you've really got to grab them when they come. Because you're not going to get 500 great opportunities.
You would be better off if you got a punch card with 20 punches on it and for every financial decision, you made you used up a punch. You get very rich because you'd think very hard, each one. I mean you went to a cocktail party and somebody talked about a company, he didn't even understand what they did or couldn't pronounce the name but they made some money last week and another one like it. You wouldn't buy it if you only had 20 punches on that card. There’s a temptation to dabble particularly during bull markets.
In stocks, it's so easy. You know, easier now than ever because you can do it online. You just click it then and maybe goes up the point and get excited about that, you buy another one the next day, and so on. You can't make any money over time doing that. But if you had a punch card with only 20 punches, you weren't going to get another one in the rest of your life you would think a long time before every investment decision and you would make good ones and you'd make big ones and you probably wouldn't even use all 20 punches in your lifetime but you wouldn't need to.”
You don't have to follow the stock market to know that Warren Buffett is hands down the greatest investor of all time. With that being said, you would think that he has made hundreds or thousands of successful investments throughout his illustrious career but you may have been surprised to learn that Buffett attributes his remarkable investment success to just a limited number of investments. While Buffett's company; Berkshire Hathaway now owns hundreds of companies and stocks. It wasn't always that way when Buffett was younger. He had an extremely concentrated portfolio of stocks. When he was 21 years old, he liked the stock of GEICO so much that he put half of his entire net worth into this one stock.
Conventional wisdom says that an investor should diversify his or her investment portfolio across many stocks in varying sectors of the economy. Investing textbooks and college finance professors say that risk is reduced by spreading your money among a significant amount of stocks.
Why does Buffett differ in his approach? From my study of Warren Buffett, there are four main reasons I point to why the strategy of running a concentrated portfolio has worked for Buffett.
Here are the reasons why Warren Buffett does not diversify
The first reason is that;
1. Buffett views stocks as ownership stakes in businesses, and not just pieces of paper that float around in price.
Since Buffett truly understands the underlying fundamentals of the business, he is not worried about short-term price fluctuations.
2. Buffett views risk differently than most investors.
Conventional investing wisdom views risk as volatility or to put it simply how much a stock price moves up or down. Buffett is different. Instead, he defines risk as the likelihood of a permanent loss of investment capital due to deterioration and the underlying performance of the business. Not short-term movements in the company's stock price.
3. Buffett invests in companies when there's a high margin of safety.
This means that he's investing in a company only when the price he is paying for a stock is significantly less than the true value of the business put another way; Warren Buffett only buys a stock when he's getting it at a discount relative to the actual value of the business. This helps him ensure that the probability of his investment being successful is high. Meaning he feels more comfortable making a large bet because the likelihood of it working out is high.
4. Warren Buffett tends to stay away from technology stocks that are susceptible to rapid change due to technology.
This is because tech companies can easily have their businesses destroyed due to unexpected technological shifts in society or by a competitor entering the market with superior technology. The lifespan of a tech company is significantly shorter than non-technology businesses such as a railroad. This makes large concentrated investments in tech companies very risky because of a higher probability of permanent capital loss. This is why venture capitalists that mainly focus on technology companies spread their investments out over a wide range of companies. They know most of their investments will likely fail but the ones that do work will more than makeup for all the ones that do fail.
So now that we understand the logic behind why Buffett recommends a concentrated portfolio; here's one of the best analogies I’ve ever heard from Warren Buffett when it comes to portfolio diversification. While many professional investors and academics would say an investor needs a lot of stocks in his or her portfolio to be diversified, Buffett strongly disagrees. He uses the hypothetical example of a local businessman. He says:
“Imagine a businessman in your hometown; let's say this businessman owns the local McDonald’s franchise, the most successful car dealership in town, some rental properties, and a factory that manufactures a product. Even though this businessman only owns four businesses, wouldn't you say that his wealth is pretty diversified? Of course, you would. So how is it any different with stocks?”
Since stocks are just partial ownership of a business. Warren Buffett makes the argument that you should focus on your best ideas as opposed to buying stocks you don't like as much for the sake of having a diversified portfolio.
There is another important question that needs to be answered because Buffett is a huge fan of portfolio concentration. Does that mean that everyone should be this concentrated? The clear answer is no.
Researching investments is time-consuming. Investors have to filter through hundreds or even thousands of companies to find just a handful they can understand, have strong business fundamentals, and are selling for a reasonable price. Buffett recommended that people who don't want to put in the work to learn about investing and spend time researching stocks should do the opposite of what he talked about in this article.
Buffett recommends these people broadly diversify. In particular, he recommends investing in an S&P 500 Index Fund. The S&P 500 is a stock market index composed of the largest 500 companies listed on stock exchanges in the United States. It is one of the most closely filed equity indices. This means that investors who put their money into this index have that money spread out among the 500 largest publicly traded companies in America. This helps ensure that investors aren't overly exposed to any one particular stock, but instead own a piece of American business.
While this strategy 100% guarantees that you won't outperform the market, it also ensures that you won't underperform the market. Many investors are perfectly fine with receiving the average return of the S&P 500, which on average has been a historic annualized average return of around 10% since its inception in 1926.
Another question you should be asking yourself is, why does Warren Buffett preach portfolio concentration while also owning hundreds of different businesses and stocks through his holding company Berkshire Hathaway?
The reason for this is the size of Berkshire Hathaway's investment portfolio. When you include cash, the portfolio Buffett manages is approaching $400 Billion. This means that Buffett is managing a portfolio the size of the entire annual GDP of countries such as Denmark, Ireland, and Colombia. There just simply aren't enough companies large enough that Buffett can run a concentrated portfolio as he prefers. As a result, the portfolio he manages has become much more diversified than in the past. Buffett attributes the size of the portfolio to its diminishing return performance.
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