"Wide diversification is only required when investors do not understand what they are doing." -- Warren Buffett (Trades, Portfolio)
The above quote from Warren Buffett (Trades, Portfolio) has been widely disseminated online, as a defense against using a well-diversified portfolio. Buffett isn't the only investor to issue advice against diversification; he just happens to be the most famous and the most successful. There are plenty of other investors who have issued guidance on the topic.
It makes a lot of sense that, if you want to get rich, you concentrate your bets on a few select investments -- or even just one investment/company. Look at Jeff Bezos and Mark Zuckerberg for example.
But while it is true that the most successful investors have made the bulk of their profits in a few select positions, there are several drawbacks to using this approach. It isn't suitable for everyone.
Survivorship bias
One of the biggest problems in following the advice of famous investors and business people is survivorship bias.
Following the advice of Buffett on how to invest is perfectly acceptable, but it only touches on the positives. As Charlie Munger (Trades, Portfolio) has famously said, the best way to find a solution to any problem is: "Invert. Always invert."
Yes, Buffett and a handful of other investors may have made a fortune by using a concentrated portfolio approach, but how many others have failed? I don't have the exact numbers, and I think it would be impossible ever to calculate. But I'm willing to bet that there are many more investors out there who have failed by investing a large percentage of their net wealth in just one company.
That being said, there are going to be many different reasons for these failures.
Starting at the top, we know Buffett is one of the most dedicated, rigorous and intelligent stock analysts around. He will only invest when he is 100% sure he is going to make a profit. Since 99.99% of other investors don't have the same commitment or level of intelligence, being concentrated is vastly riskier for most. Buffett can significantly reduce risk through research.
Second, Buffett is actually diversified. In fact, he's probably more diversified than most other investors.
Let's consider the state of the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) conglomerate today. As well as the equity portfolio, Berkshire has more than 60 subsidiaries, everything from ice cream and candy to fine jewelry, insurance, newspapers, railroads and utilities.
If you consider the fact that the Dow Jones Industrial Average only has 30 constituents, Berkshire Hathaway is in effect an index, and that is excluding equity holdings. Rather than benefiting from a concentrated portfolio, today Buffett is benefiting from the exact opposite.
His sprawling empire is diversified enough that it can generate profits in any market environment. Indeed, this diversification helped the group not only survive the financial crisis but remain healthy enough to bail out others. If Buffett had concentrated in his entire business in one sector, say insurance, for example, it is highly unlikely he would have been able to do this.
Another factor to consider here is net wealth concentration. Most investors are investing retirement savings, which tend to form the bulk of assets for the average joe. Buffett has been able to use a concentrated approach to investing because he's always been able to distinguish easily between investment capital and personal savings. His level of research and intelligence have helped as well, but he has never risked the farm.
A significant loss to the average investor would be more damaging than the equivalent loss to Buffett. Of course, it's highly unlikely Buffett would make such a mistake because he puts in the extra research an effort, but this does not apply to the average investor.
What I am trying to get at here is the conclusion that you are not Warren Buffett and while his advice might be to avoid diversification, this is not appropriate advice for every investor. Some investors are better suited to it than others; you have to work to a level of concentration you are personally happy with.
Disclosure: The author owns shares in Berkshire Hathaway.
