Warren Buffett: How Diversified Should You Be?
One of the biggest decisions any investor has to make is to determine how diversified they want to be. On one end of the spectrum, there are passive investors who want to be perfectly diversified and own the entire market. On the other end, there are investors who are comfortable with owning only a handful of stocks that they really believe in.
Which strategy is best for you? Warren Buffett (Trades, Portfolio) offered his thoughts on this subject at the 1996 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual shareholder meeting.
Be very diversified or concentrated
On some occasions, Berkshire has been very concentrated in a handful of stocks - in 1987, for instance, it had only three in its equity portfolio. At other times, it has been more diversified. So where does the Oracle of Omaha stand on the question of diversification?
Buffett believes that diversification is "protection against ignorance." Although he himself has obviously had enormous success as a stock-picker throughout his own life, Buffett has on many occasions said that the best investment decision that an average person can make is to put their savings into a cheap index fund that owns a wide range of different stocks. You either have the skill to value businesses, or you don't. If you do not, then it would be negligent to not invest in some kind of index fund.
On the other hand, Buffett believes that if you do know how to value businesses, then it makes no sense to be excessively diversified:
"If you know how to analyse businesses and value businesses, it's crazy to own fifty stocks or forty stocks or thirty stocks, because there aren't that many wonderful businesses that are understandable to a single human being, in all likelihood. And to have some super wonderful business and then to put money into number thirty or thirty-five on your list of attractiveness and forego putting money into number one, just strikes Charlie [Munger] and me as madness. And it's conventional practice, and it may - if all you have to achieve is average - preserve your job. But it's a confession, in our view, that you don't really understand the businesses that you own."
If you are going to actively manage your money, it seems a lot more rational to concentrate on identifying the top five or top ten best companies out there than it is trying to find the best hundred. For one thing, no one person has the computational capacity in their brain to hold all the required information on so many different businesses. For another, the gap between number one on your list and number one hundred is likely to be so big that it makes no sense to even consider investing in the latter.
The bottom line is that while not everyone should actively pick businesses if they want the best returns, those that do should have the conviction to double down on the ones they really believe in.
Disclosure: The author owns no stocks mentioned.
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This article first appeared on GuruFocus.
