"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.
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.
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.
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!