Buffett on Diversification

Buffett on Diversification

Warren Buffet’s ideas on diversification strategy seem to be the opposite of most modern portfolio managers. Modern portfolio theory states that the primary benefit of a broadly diversified portfolio is to buffer the price volatility of any individual stock in the portfolio. Buffett is less concerned with price volatility, so his views on portfolio diversification dramatically different from the modern portfolio theory.

Part of Buffett’s view on diversification stems from his unique assessment of risk. While modern portfolio theory defines risk as the volatility of a share price, Buffett looks at it a bit differently. He sees risk as misjudging any one of the following 4 business factors:

Not properly evaluating the long-term economic characteristics of a business.
Not accurately evaluating the management’s ability to realize the full potential of the businesses and to wisely employ its cash flows.
Not being able to count on management to channel the rewards from the business to the shareholders rather than to itself.
Not being able to purchase the business shares for a good price.
Buffett sees a strong link between an investors time horizon and risk. If you buy a stock today with the hope to make a contra gain (sell for a profit in 3 days), then you have entered into a very risky transaction. The odds of predicting the short-term price movement of any stock is no better than calling a coin toss heads or tails. You will lose half the time. However, if you extend your time horizon to several years, the probability of your transaction being risky drops significantly, assuming, of course, that you made a sensible purchase. Buffett says, If you asked me to assess the risk of buying Coca-Cola this morning and selling it tomorrow morning, I’d say that that’s a very risky transaction. But, if I buy Coca-Cola and hold it for 10 years, that carries zero risk.

Diversification is Protection against Ignorance
The strategy we’ve adopted precludes our following standard diversification dogma, says Buffett. Many pundits would therefore say the strategy must be riskier than that employed by a more conventional investor. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.

So, by focusing on fewer, more carefully selected stocks, Buffett believes he is able to study them more thoroughly and better understand their intrinsic value. He believes the more knowledge you have about your company, the less risk you are likely to be taking.

Diversification serves as protection against ignorance, explains Buffett. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There is nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyze businesses.

A novice investor, or one not willing (or to busy) to spend time studying their investment choices carefully, would almost always be better off owning the entire market--buying a low cost passive index fund. In many ways, Buffett implies that modern portfolio theory teaches amateurs and professionals alike how to perform in an average manner, avoiding the risk of underperforming badly...as well as limiting the ability to outperform dramatically along the way.

How Many Stocks Should an Investor Own?
I wouldn’t want to buy anything where I wouldn’t want to put 10% of my net worth into it, says Buffett. If I don’t want to put that into it, then it just isn’t much of an idea.

Buffett believes that if you develop the ability to analyze and value businesses, then you are not likely to need many stocks. The only investors who need wide diversification are those who do not understand what they are doing.

Buffett has reinforced many times that a serious investor must act like an owner of the business, not just the shares. As such, there are no laws or rules that state you must own some businesses in every industry, and no requirement that you buy 50 or 100 different businesses. If a business owner would be happy (and busy enough) owning 10 companies, why, asks Buffett, should it be any different for an owner of common stocks?

Wide diversification is a two-edged sword. You protect against severe losses, but you lose opportunity for dramatic gains. Even mathematicians agree, a 15-stock portfolio achieves 85% of the available diversification benefits. Buffett adds, If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your 20th favorite business rather than add money to the top choices?

Sage@wallstraits.co