If you want to be a successful investor, you'd do well to imitate Berkshire Hathaway CEO Warren Buffett. When Buffett took over at Berkshire in the 1960s, the stock traded for less than $15 per share. Today, it trades at over $400,000. And the increase in shareholder value is due to astute investments from Buffett and company.
Buffett's Berkshire often acquires companies outright. But it also invests in shares of public companies. If you were to glance at its holdings, you would conclude that it's betting the farm on Apple (AAPL -0.35%), Bank of America, Chevron, and Coca-Cola -- these four stocks account for more than half of the value of its portfolio.
But don't rush out to concentrate the majority of your net worth in just a few investment ideas like Buffett. If you want to be successful like him, there's some indispensable context for Berkshire's portfolio that you must understand first.
Why you need a diversified portfolio
If you're going to invest the Motley Fool way, you need to commit to buying at least 25 to 30 stocks. Buying this many means that you should aim to invest between 3% and 5% of your money in each stock. Betting the farm on just a few stocks is discouraged.
The diversified-portfolio approach recognizes two rock-hard truths about investing. First, some of your investments will be bad ones because plenty of unforeseen, adverse things will happen. Second, just a handful of stocks drive lasting, long-term returns, so you want to buy enough stocks to give yourself a chance at one of the great ones.
I'll back up both points. And I'll back up the first one using Buffett himself.
In 2012, Berkshire Hathaway owned a position in European grocery store chain Tesco, a position it had acquired for $2.3 billion. In the 2014 letter to shareholders, Buffett noted that it had exited its position at a $444 million loss -- 19% of their original investment -- because of quickly deteriorating operating results and a series of managerial mistakes. The following year, Buffett wrote: "I will commit more errors; you can count on that. If we luck out, they will occur at our smaller operations."
As I said, some of your investments will be bad ones.
To my second point, Hendrik Bessembinder of the W.P. Carey School of Business published a study in 2018, which found that, from 1926, just 4% of stocks were responsible for all the stock market's gains -- just one stock out of every 25. You're unlikely to create a portfolio built entirely of these select few life-changing investments. However, your odds of finding at least one of them go up by buying more stocks.
To reiterate, just a handful of stocks drive lasting long-term returns.
Both of these truths underscore the need to have a diversified portfolio.
Context for Buffett's words
Students of Warren Buffett likely disagree. After all, Buffett and his investing partner Charlie Munger seem opposed to the idea of diversification. They sound like people who prefer to bet the farm on a stock like Apple.
Munger has said that investors run the risk of over-diversifying -- something he calls "diworsification" -- after just five stocks.
Similarly, Buffett has said, "Diversification is a protection against ignorance." He also said that diversification "makes very little sense for anyone that knows what they're doing."
Who wants to ignorantly over-diversify when greats like Buffett and Munger say not to?
While, as mentioned, Apple, Bank of America, Chevron, and Coca-Cola make up more than half of Berkshire's portfolio, keep in mind that Berkshire actually owned nearly 50 stocks and one exchange-traded fund (ETF) as of March 31. Moreover, Berkshire created or added to 15 different positions in the first quarter of 2022 alone, according to Forbes. So much for over-diversifying after five stocks.
Therefore, Buffett and Munger are actually practitioners of diversification. And if diversification is good enough for these two greats, it should be good enough for you too.
But what about the Apple farm?
We've clearly seen the need to build a diversified portfolio. But there's another principle investors should embrace: Hold on to your winners for the long haul. Again, Buffett exemplifies this perfectly with Apple.
To double back, statistically, just one in 25 stocks will drive the majority of returns. If that's true, it would be insane to sell that one position, or even a portion of that position, once it became a large part of your portfolio. The most logical thing to do is let it run because odds are you won't reinvest that money in something just as good or better.
For Buffett's part, Apple stock is up around 400% since Berkshire started buying in 2016. It now accounts for nearly 40% of the portfolio's value. But this is largely due to appreciation -- Berkshire did not put 40% of its cash in the stock.
The same could be said of its outsized positions in Bank of America, Chevron, and Coca-Cola: They've gone up.
Without context, you might think that you should invest 40% of your portfolio in one stock. But now we've seen that Buffett actually exemplifies a diversified approach but allows good investments to keep going up. And this is precisely what everyday investors should be doing too.
Knowing when to sell a stock is a separate discussion. Maybe the day will come for Berkshire to sell or trim its position in Apple. But for now, Apple is still posting quarterly records for revenue and returning tons of cash to shareholders, meaning Buffett will likely keep letting this winner win for a while longer.
