Warren Buffett on When Diversification Makes Sense

Thoughts from the 1994 Berkshire annual meeting

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Sep 09, 2020
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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.

There is no correct answer to this question. Some investors might be happier with a concentrated portfolio. Others may not be able to tolerate the volatility.

However, whichever course of action you decide to take, it is essential to understand why you have taken this decision and the factors that have influenced your diversification plan.

Warren Buffett on diversification

Warren Buffett (Trades, Portfolio) has famously said he is against diversification. "Diversification is a protection against ignorance," Buffett once said. "[It] makes very little sense for those who know what they're doing."

This is true, to a certain extent. Buffett has allocated as much as 40% of his portfolio to just one stock in the past.

We need to understand why he did this. He didn't do it just because he thought the company had good prospects. That was only part of the equation.

When running his investment partnerships, the Oracle of Omaha would regularly take large positions in companies because he wanted to influence their management. This is almost an activist style of investing. Buffett coupled his desire to unlock value with an insatiable desire to learn about the companies he owned. 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.

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. Buffett explained this mentality at the 1994 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of investors:

"We're not going to do that unless we think we understand the business very well, and we think the nature of the business, what we're paying for it, the people running it, and all of that lead up to virtually no risk, and β€” But you find those things, occasionally. And we would put β€” assuming it were that much more attractive than the second, and third, and fourth choices β€” we would put a big percentage of our net worth in it. We only advise you to do that β€” well, we probably don't advise you to do it all, maybe β€” but we would only advise you to do it, if you're doing it based on your conclusions about β€” your own ideas of value, and something that you really feel you know enough to buy the whole business, if your funds were sufficient, and it was being offered to you. You ought to really understand the business."

To put it another way, I think Buffett and other investors' comments on diversification should not be taken at face value. There is much more to the diversification argument than simply buying a lot of a company just because you like its prospects. You need to understand how the company works and how it will achieve what it sets out to do.

If it is impossible to establish these factors, it might not be worth investing at all, or it could be better to take a smaller position. Yes, this would go against Buffett's advice, but it would also protect you from uncertainty. That is far more important in the long-run (Buffett would certainly agree).

If you are not comfortable with the level of risk involved with taking a large position, then it is best not to do it at all. It is as simple as that.

Disclosure: The author owns shares in Berkshire Hathaway.

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