What did Warren Buffett say about diversification?
When it comes to the topic of diversification, there are two schools of thought. Some believe diversification is a waste of time, while others think portfolios should be widely diversified. 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.
However, some of the best investors, like Warren Buffett, George Soros, William J. O'Neil and Bernard Baruch spoke about the virtues of holding concentrated positions. “Diversification is a protection against ignorance," according to Buffett. "It makes very little sense for those who know what they’re doing.”
“It is unwise to spread one’s funds over too many different securities," said Bernard Baruch. "Time and energy are required to keep abreast of the forces that may change the value of a security. While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues.”
Of course, selecting stocks for a concentrated portfolio requires a lot of analysis and attention. An investor with a concentrated portfolio needs to put the work in and must know as much as possible about their investments. They should be listening in on earnings conference calls, studying financials and tracking the business environment carefully.
How Warren Buffett started investing?
When he was 11 years old, Buffett kicked off a lifetime of investing by buying three shares of Cities Service Preferred at about $38 per share. Buffett eventually sold the stock at $40, making a profit of $2 per share, but he learned an important lesson about patience when the price later shot up to $200 per share. 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. Did he do it just because he thought the company had good prospects? We need to understand why he did this. Why does Buffett differ in his approach?
He employed a method similar to Phil Fisher's Scuttlebutt method. He learned everything he could know about a company before making a substantial investment. He looks at how the company has progressed and what its strategy is. He investigates thoroughly and acts deliberately—and infrequently. Once he has purchased a company or shares in a company, he is loath to sell. For example, in his first large public investment, GEICO, the young investor spent a day talking to the man who would later become the company's CEO. By the time he finished, he had understood the business exceptionally well. This gave him the confidence to take such a large position.
Warren Buffett never liked the idea of too much diversification
If you look at Berkshire Hathaway's portfolio at the end of the first quarter of 2021, you'll notice that it has 50 positions. However, that's very small compared to other investment firms that have as many as 4 or 5 times that. For Warren Buffett, diversification is a protection against ignorance.
When your portfolio has three stocks the risk and profit potential is more and when your portfolio has fifty stocks then risk and expected profitability both will be low. This happens because due to over diversification the profits and losses of stocks will cancel out each other therefore lowering the overall profitability of your portfolio. If you look at Warren’s (Berkshire Hathaway’s) publicly listed portfolio, 45% is in Apple. This is an illustration is that if you have strong conviction in a stock, don’t think about it too much - as long as it ticks the boxes. Because it makes more financial sense to keep the bulk of your invested capital in your best idea, not your 3rd, or your 5th. Once you have achieved a certain knowledge benchmark (attainable by the large majority), diversification is a statement that you are risk-averse - as opposed to risk-neutral.
It is better to select two good quality stocks from each sector and keep investing as per the season. For example, invest in fertilizer during monsoon and sowing time, financial sector, auto during festive season, FMCG n pharma altime etc. I suggest to analyse for risk taking capacity and invest. Let's not get exposed to unknown unknowns just because we need to diversify.
How is Warren Buffett diversified?
What Buffett is calling “diversification” is a portfolio with 50% in 5 stocks and another 30% in about 15 stocks. By today’s standards, this portfolio would be considered intensely focused and not at all diversified. He calls what your fund manager is doing buying 100 stocks a vast “over-diversification” that is sure to result in mediocre returns, returns that are less than the market itself because of your fund manager’s fees.
From my study of Warren Buffett, which includes reading every essay he has written since 1965 and watching every interview he has given, there are 4 main reasons I point to as to why this strategy of running a concentrated portfolio has worked for Buffett.
The first reason I point to is that Buffett truly 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.
That leads me to my second point, Buffett views risk differently than most investors. Conventional investing wisdom views risk as volatility or to put 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 in the underlying performance of the business, not short term movements in the company’s stock price.
The third reason is that Buffett invests in company’s when there is a high margin of safety. This means that he is 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 is getting it 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.
The final reason is that Warren Buffett tends to stay away from technology stocks that are susceptible to rapid change due to technology. Because tech companies can easily have their business destroyed due to an unexpected technological shift in society or by a competitor entering the market with a superior technology, the lifespan of tech companies is significantly shorter than non technology businesses, such as a railroad. This makes large, concentrated investments in tech companies risky, because of the higher probability of permanent capital loss. This is why venture capitalists who 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 make up for all the ones that do fail.
How many stocks should a person own?
Over diversification reduces the risk and also the profit potential. Over diversification is therefore a point where the loss of expected return is higher than the benefit of low risk. Therefore investors should diversify their portfolio to a reasonable limit and not over diversify it in order to enjoy the benefits of diversification.
One thing the investor should also remember is that though an over diversified portfolio reduces your return but it reduces your risk too. Hence to my mind, the new investor should initially make a portfolio of say 30 to 35 stocks giving less weightage to stocks and as he or she gains experience over a period of time he should reduce the number of stocks and ultimately should construct a 10 to 20 stock portfolio.
Diversify as per your capacity to manage, if you can manage 1000 different counters, please do it.
