I recently listened to an interview that Warren Buffett (Trades, Portfolio) did in April of 2011 with Ajit Jain in India, where he talked about what he refers to as the Noah’s Ark approach.
Specifically, he said:
“We believe in making big bets when we know we’re right. I mean the idea of doing a little of this, a little of that; I call it the Noah’s Ark approach. I mean, we do not want a zoo when we get through with two of every animal. We want to concentrate on things that we really understand and when we find something good, we take a big swing at it.”
Concentrate on what you really understand
This emphasizes Buffett's approach of concentrating on a few companies that are within his circle of competence. Ideally, he would be more than happy to invest even 50% of his net worth, if not more, in one single acquisition if he found the right deal.
Today, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) is so big that it is rather difficult for him to acquire such an entity, so he is forced to have a much larger portfolio than he would desire. Early on in his career, when his net worth was lower, he had a much smaller portfolio and a higher concentration of capital in fewer companies.
He has also said, “The stock market is a no-called-strike game. You don’t have to swing at everything – you can wait for your pitch. The problem when you are a money manager is that your fans keep yelling, ‘Swing, you bum!’”
Therefore, investors should be patient and remain in their circle of competence. When the time is right and they find the right company that is temporarily undervalued, they can then swing at it with all they have.
Is this approach for everyone?
This investment approach is the opposite of what most financial advisers would suggest, but Buffett clarified that it is not for everyone.
He noted that investors do not need to have a well-diversified portfolio if they know what they are doing and have the knowledge and the time to invest actively.
For skilled investors, it makes no sense to diversify since this kind of portfolio diversification will only reduce their returns. Therefore, in this scenario, they should follow Buffett’s advice and invest in very few businesses that they understand and are within their circle of competence.
Who should have a widely diversified portfolio?
Portfolio diversification, on the other hand, is meant to protect investors from their ignorance, and there is nothing wrong with that. Therefore, if an individual does not have the knowledge and time to analyze companies, it is better to invest directly in an index fund like the Vanguard S&P 500 ETF (VOO, Financial) or SPDR S&P 500 ETF Trust (SPY, Financial). Over the long run, these kinds of low-cost passive index funds often also provide higher returns than the ones achieved by many professional active investors.
For those who do not have the knowledge and are not comfortable investing directly in specific companies, Buffett advises them to stick to passive index funds with ultra-low fees, transparencyand tax efficiency.
