The topic of diversification seems to be one of the most hotly debated in finance.
On one hand, you have those investors who believe that diversification is not required if you do your research correctly, and diversification is just an excuse for those who cannot be bothered to do the extra work.
On the other hand, you have investors like Ray Dalio (Trades, Portfolio) who have made billions for themselves and their investors by using extremely diversified portfolios to execute sophisticated trading strategies.
Buffett on diversification
Warren Buffett falls into the first category. He has never had a particularly diversified portfolio and has always concentrated his funds in his top few positions.
At the 1996 annual meeting of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders, he described diversification as "protection against ignorance" because if you want to make sure that nothing bad happens to you relative to the market, you own everything.
He went on to say, "There's nothing wrong with that," and it is a perfectly sound approach for someone who does not understand how to analyze businesses. Indeed, throughout his career, Buffett has always tried to make it clear that he believes the average investor should just buy an index fund and hold, rather than try to pick stocks themselves since evidence shows they cannot succeed.
But if you know how to analyze businesses and stocks, "It is crazy to own 50 or 40 stocks or 30 stocks," the Oracle of Omaha went on to explain. The reason he thinks this is the case is that "there aren't that many wonderful businesses that are understandable to a single human being."
This is a fantastic quote and one that really takes us back to the whole circle of competence idea.
Diversification and the circle of competence
Research is one of the best ways to reduce risk in investing, and one of the best ways to ensure that your research is correct is to analyze businesses only in sectors and industries you know and understand.
Most human beings will only have a deep understanding of one or two particular sectors, and investing in the best company in both of these sectors will only leave you with a portfolio of two stocks. This is an extreme example, but it clearly illustrates Buffett's quote. Indeed, at the 1996 meeting, he went on to say:
"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 number one, just strikes Charlie and me as madness.
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..And within Berkshire, I could pick out three of our businesses. And I would be very happy if they were the only businesses we owned, and I had all my money in Berkshire.
Now, I love it — the fact that we can find more than that, and that we keep adding to it. But three wonderful businesses is more than you need in this life to do very well....
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."
But as noted above, this approach makes sense only for a small segment of the investment community. Investors who do not know how to analyze businesses would be better served buying a low-cost index fund, and the same applies to investors who cannot tolerate volatility.
Still, for those who do understand how to analyze businesses, picking the best in a sector you know and understand well, and concentrating your efforts on this one business seems like a sensible approach, because, as Buffett alluded to in the quotes above, no human can realistically keep track of 30 different companies in different industries.
Disclosure: The author owns shares in Berkshire Hathaway.
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