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Rupert Hargreaves
Rupert Hargreaves
Articles (1044)  | Author's Website |

Warren Buffett: Diversification Is 'Protection Against Ignorance'

Some thoughts on why diversification is not always a sensible strategy

January 13, 2020 | About:

Every investment strategy should be built around the principle of reducing risk, and one of the easiest ways to minimize risk with an investment is with research.

Risk has to be one of the most misunderstood concepts in finance. It is all too easy to say that you would like to follow a reduced-risk strategy, but implementing this goal is the hard part.

It all comes down to how are you define risk. Some investors define risk as volatility. For others, reducing risk is all about reducing the chances of permanent capital impairment. Students of Benjamin Graham would likely follow the latter approach.

There are some shortcuts investors can use to define this type of risk. For example, I am staying away from companies with high levels of borrowing. However, even these shortcuts will not eliminate the risks involved with any specific investment.

The only way to truly understand every risk that may impact a company is with research.

Diversification and ignorance

Research can also eliminate the requirement for diversification. In fact, if you are doing your research, according to Warren Buffett (Trades, Portfolio), there's no need for diversification at all.

At the 1996 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders, Buffett declared that diversification is a "protection against ignorance."

He went on to add that any investor who knows what they're doing should not feel the need to diversify at all, because they would only buy the companies they truly understand:

"If you know how to analyze businesses and value businesses, it's crazy to own 50 stocks or 40 stocks or 30 stocks, probably, because there aren't that many wonderful businesses that are understandable to a single human being, in all likelihood.

And to have some super-wonderful business and then put money in number 30 or 35 on your list of attractiveness and forego putting more money into number one, just strikes Charlie and me as madness.

And it's conventional practice, and it may — you know, if you all you have to achieve is average, it may preserve your job. But it's a confession, in our view, that you don't really understand the businesses that you own."

One of the great things about investing is that no investor is ever under the obligation to buy a stock or asset. We only need to purchase the investments we understand, when we want to buy them. Selling is another process altogether, but that's a discussion for another day.

As a result, investors should never make a trade just because they think they should. Every investment should be backed up by research and a solid understanding of the opportunity.

No time to buy

If you don't have time to analyze the business, or don't understand how to analyze companies in general, that's completely fine. There are plenty of index and mutual funds on the market you can buy and let others manage your money for you.

However, buying a security when you don't understand the underlying business and haven't done enough research is just plain silly. Rushing into something and purchasing an investment just for the heck of it is almost sure to end badly.

Still, as mentioned above, there is never any obligation to make an investment in anything. So, if you don't feel comfortable buying a stock, don't.

This is something I've had to deal with on many occasions. I will admit that I have let the market drive my decisions by focusing on what the stock price was doing (I will have to buy now or the price will go higher) rather than fundamental value.

Something I've learned is that there will always be opportunities to make money in the market. Missing one or two or even 10 in a row is not a disaster. It is better to understand what you are getting involved with first before rushing to buy something you might not fully comprehend.

Disclosure: The author owns shares in Berkshire Hathaway.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


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