"You know, we think diversification is — as practiced generally — makes very little sense for anyone that knows what they’re doing ... Diversification is protection against ignorance."
Warren Buffett (Trades, Portfolio) said the above at the 1996 Berkshire Hathaway annual meeting of shareholders. He was responding to a question from one of the audience members, who asked him to explain why, in some years, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) reported only three stocks in its public equity portfolio.
The Oracle of Omaha initially responded by saying that this statement was incorrect, because, on some occasions, the conglomerate had shareholdings that were not worth reporting, and, therefore, were not displayed to investors. He then went on to offer some advice to listeners about diversification.
Buffett on diversification
After saying the above, Buffett went on to state, "Nothing bad happens to you relative to the market" when you own everything, and this is a perfectly "sound approach" for somebody who does not feel they know how to analyze businesses.
However, for investors and analysts who think they know and understand how to evaluate businesses, diversification is "crazy," the Berkshire Hathaway chairman went on to say. He added:
"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 No. 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."
After stating the above, Buffett went on to say that he could pick two or three of the companies in the Berkshire Hathaway portfolio, and he would be happy if they were the only businesses "we owned, and I had all my money in Berkshire."
While many investors and active mutual fund managers think it is perfectly acceptable to have a well-diversified portfolio of 50 companies or more if you look at how the world's wealthiest people have achieved their fortunes, it hasn't been with diversified portfolios. As Buffett went on to point out when replying to his shareholder, fortunes are built "by someone who identified with a wonderful business. Coca-Cola’s a great example. A lot of fortunes have been built on that."
The problem is finding these wonderful businesses. There are only ever going to be a handful of them.
"And there aren’t 50 Coca-Colas. You know, there aren’t 20. If there were, it’d be fine. We could all go out and diversify like crazy among that group and get results that would be equal to owning the really wonderful one.
But you’re not going to find it. And the truth is, you don’t need it. I mean, if you had — a really wonderful business is very well protected against the vicissitudes of the economy over time and the competition."
Finding these wonderful businesses is not easy, but it is also not impossible. And when you do find them, it does not make any sense only to own them as part of a while diverse portfolio. As the Oracle of Omaha summarized:
"But I can assure you that I would rather pick — if I had to bet the next 30 years on the fortunes of my family that would be dependent upon the income from a given group of businesses, I would rather pick three businesses from those we own than own a diversified group of 50."
Of course, if you don't have the experience and are not comfortable running a relatively concentrated portfolio, then this approach won't be for you. But it is always interesting to know and understand the reasoning for Warren Buffett (Trades, Portfolio)'s investing principles.
Disclosure: The author owns shares in Berkshire Hathaway.
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