Why Warren Buffett Doesn't Diversify (Too Much)

"We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts." -- Warren Buffett, 1978 Berkshire Hathaway letter to shareholders 

Just about any book, article, or class purporting to be an introduction to investing will urge you to "diversify." According to the conventional wisdom, by owning stocks for a large number of companies in different sectors, you can reduce your risk in the event of problems affecting a single company or industry.

Warren Buffett didn't become a legendary investor by focusing on diversification

Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) CEO and investing legend Warren Buffett would urge investors to take that conventional wisdom with a big grain of salt. Indeed, Buffett has consistently avoided diversification when investing at Berkshire Hathaway. Instead, he has made big bets on a few companies like Coca-Cola (NYSE: KO  ) and American Express (NYSE: AXP  ) .

Stick to your best ideas
Buffett's main insight here is that it's very difficult for a single person -- even Warren Buffett -- to have unique insights about dozens of stocks across all industries. There are a few areas that Buffett knows well and is comfortable investing in: insurance, banking, media, and consumer goods are some of his favorites.

Buffett understands these areas well enough that when he becomes convinced a particular stock is undervalued, he is confident enough to make a big investment. Moreover, when he's been right, Buffett has usually been willing to let his money "ride" rather than selling for quick profit.

Buffett takes on a lot of risk by owning such a concentrated portfolio at Berkshire Hathaway. However, it makes a lot of sense when you consider Buffett's alternative: investing in companies that he doesn't understand or that he doesn't like as much as his top holdings.

Two big Buffett buys
Berkshire Hathaway's investments in Coca-Cola and American Express show just how committed Warren Buffett is to holding an undiversified portfolio. At the end of 1999, Berkshire Hathaway had $11.65 billion of Coca-Cola stock and another $8.40 billion of American Express stock. Together, those two stocks made up more than $20 billion of Berkshire's $37 billion stock portfolio.

Warren Buffett made a big bet on Coca-Cola in the late 1980s, and it paid off handsomely

By that point, Buffett had been investing in both companies for about a decade. Berkshire Hathaway continues to have large ownership stakes in American Express and Coca-Cola today, as Buffett has remained satisfied with the long-term prospects of both companies.

By contrast, Buffett has generally avoided buying tech stocks at Berkshire Hathaway, with the notable exception of a recent investment in International Business Machines (NYSE: IBM  ) . It's not because Buffett is anti-technology or thinks tech companies are all bad investments. However, he realizes that he doesn't understand the tech industry well enough to have the same level of confidence he has about other investments.

The alternative: diversification
For individual investors, there are two main ways to build a diversified portfolio. One option is to buy stocks and bonds from lots of different companies or organizations. Alternatively, you can invest in one or a few broad index funds.

For many people, buying and holding a broad index fund -- or a few such funds -- is a smart move. Index funds tend to have low transaction costs and allow investors to achieve returns that mimic the performance of the market as a whole (or a particular sector). If you are patient, this strategy promises good long-term returns with relatively low risk.

By contrast, buying lots of stocks in an attempt to "diversify" is almost always a bad idea. If Warren Buffett can't find dozens of companies that he's excited to invest in, you aren't likely to do better in your spare time. Your best ideas may beat the market, but your 17th best idea will probably just drag down the rest of your portfolio.

Warren Buffett has bet big on top picks like American Express, rather than spreading his money around

Meanwhile, you will have to pay commissions for every time you buy or sell a stock in your big portfolio. You aren't likely to get rich from this kind of strategy -- but your broker might!

Should you follow Buffett's example?
Warren Buffett's anti-diversification strategy isn't right for all investors. If you bet big on a few stocks and you don't find the next Coca-Cola or American Express, you could face significant losses. If you are risk-tolerant, that may be OK. However, many individual investors can't afford to stake that much on a few investments.

If you fall into the second camp, but want to invest in individual stocks, your best bet is still to put most of your money in low-cost index funds to meet the goal of diversification. Then you can invest the rest in a few stocks without worrying about diversifying.

The key -- if Warren Buffett's track record is any indication -- is to stick with what you know when you invest in individual stocks. Find a few companies with business models that can thrive for decades and reasonable stock valuations. Do some research to get comfortable with their earnings power. Then bet big on your best ideas -- with any luck, you will have found some real gems!

Warren Buffett's biggest fear is about to come true
Warren Buffett just called this emerging technology a "real threat" to his biggest cash-cow. While Buffett shakes in his billionaire-boots, only a few investors are embracing this new market which experts say will be worth over $2 trillion. It won't be long before everyone on Wall Street wises up, though. That's why The Motley Fool is releasing this timely investor alert. Click here to learn more about what's keeping Buffett up at night and the one public company we're calling the "brains behind" the technology.


Read/Post Comments (4) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 20, 2014, at 1:27 PM, BuyLowBandit wrote:

    The answer, which can be realized from the title alone, is that he does diversify.

  • Report this Comment On July 21, 2014, at 6:08 PM, RossReisman wrote:

    I humbly submit to you Mr. Bandit, that you are missing the point.

    It isn't that he DOESN'T diversify it's that, whereas much of the rhetoric that beginner investors or people who are too afraid to put their money in a system they dont understand tend to hear is "diversification uber alles", Mr Buffett has shown that diversification isn't as sacrosanct as one might initially perceive.

    Respectfully,

    A Fool

  • Report this Comment On July 22, 2014, at 9:26 AM, Mathman6577 wrote:

    I think it's difficult to diversify using individual stocks (or bonds) only. The only true way is to buy index funds in both stocks and bonds (and try to find the correct balance) across all geographical regions of the world. The Vanguard All-World Fund might be the truest diversified investment in stocks.

    Good point in the article about Buffett. He doesn't really diversify because he typically buys only companies he understands (and only at a reasonable price). He'll never touch a tech stock (especially social media and Internet), therefore he "loses" out on when those stocks rally and profits when the bubble bursts.

  • Report this Comment On July 22, 2014, at 12:37 PM, notyouagain wrote:

    One comment... just one. If you want to understand why what Warren Buffet does works so well, read

    'Warren Buffet And The Interpretation Of Financial Statements'.

    Awesome. Simply awesome.

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