I often see investors and analysts quote Warren Buffett (Trades, Portfolio)'s advice on diversification when trying to justify an investment approach. However, I think Buffett's views on this matter are often misunderstood.
One of the Oracle of Omaha's most misused quotes on this topic is, "Diversification is protection against ignorance. It makes little sense if you know what you're doing." This quote taken out of context is downright dangerous as it misses a key part of the billionaire's advice.
Buffett's views on diversification
To really dig into this quote, we need to go back to 1994. At the 1994 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of investors, one shareholder asked Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), for their thoughts on position sizing and how large a position they would be willing to have for a single security in their portfolio.
As one might expect, Buffett did not give one set answer to this question, probably because there is not one. However, he did note that when he was managing his early investment partnerships, he put a limit of 40% on single holdings, even though Munger was happier to invest more than 40%.
But there were only a handful of stocks that qualified for this high allocation. This is where the diversification debate takes on more weight. Rather than arguing against diversification in 1994, Buffett tried to clarify that a concentrated portfolio should not be considered the gold standard for investors.
Instead, he explained that he would only be willing to allocate a large percentage of his portfolio to one equity if he understood the business "very well." Buffett went on to add:
"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."
There are different ways to interpret this statement, but I think it is Buffett's way of saying that a high allocation towards just one stock in a portfolio is the exception, not the rule.
For a company to meet all of his criteria, it would not only have to be a perfect business, but it would also have to be better than all the other options available to Berkshire at the time.
In fact, Buffett went on to discourage investors from using this approach at all:
"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."
If Buffett holds this view, readers might question why he is happy to invest 20% or 40% of Berkshire's portfolio in one stock, Apple (AAPL, Financial), which makes up more than 40% of the equity portfolio today.
The simple answer is that there is far more to Berkshire than just its equity portfolio. The group's overall asset value exceeds $700 billion. As component parts, BNSF, Berkshire Hathaway Energy, GEICO and Berkshire's reinsurance operations would be worth far more than the overall company's asset value. One could even argue that as stand-alone businesses, these four divisions may be worth the same, if not more than Apple.
Together, these are five businesses in four industries and five sectors. As a whole portfolio, Berkshire is highly diversified. This is worth keeping in mind when reviewing one's investment approach.
