Warren Buffett's Letter to Berkshire Hathaway Shareholders Just Reminded Investors of This Timeless Lesson

Every year, investors travel from far and wide to a city on the Missouri River to hear Warren Buffett at the Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%) annual meeting. But a couple of months before that, investors get to leaf through the wisdom that courses through the pages of Buffett's annual letter to shareholders.

This year's letter did not disappoint. In it, Buffett shared a timeless lesson that's particularly relevant in today's frothy market. Here's the key lesson, what it means, and how it can help you achieve your financial goals.

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Expecting the unexpected

Berkshire Hathaway is famous for keeping a large cash position and maintaining a level of conservatism that is uncommon among other funds and money managers. The reasoning is simple. Buffett wrote the following in the 2023 letter to shareholders:

One investment rule at Berkshire has not and will not change: Never risk permanent loss of capital. Thanks to the American tailwind and the power of compound interest, the arena in which we operate has been -- and will be -- rewarding if you make a couple of good decisions during a lifetime and avoid serious mistakes.

Avoiding big mistakes is just as important as picking good companies. But it doesn't get talked about enough because avoiding big mistakes is the habit of consistency over time, whereas a hot stock can catch the spotlight in a flash.cIf you lose half your money, you must double it to recover. Math is a tricky beast that way, but it's one reason why losses are hazardous.

Buffett was, admittedly, more risk-taking in the early years of Berkshire. But as Berkshire's assets have grown and the business has become more complicated, the company has taken great care to keep an impeccable balance sheet flush with cash, so if a downturn does occur, Berkshire will be better positioned than its peers and can even take market share. To quote the letter:

Extreme fiscal conservatism is a corporate pledge we make to those who have joined us in ownership of Berkshire. In most years -- indeed in most decades -- our caution will likely prove to be unneeded behavior -- akin to an insurance policy on a fortress-like building thought to be fireproof. But Berkshire does not want to inflict permanent financial damage -- quotational shrinkage for extended periods can't be avoided -- on [Buffett's sister] Bertie or any of the individuals who have trusted us with their savings.

Conservatism is usually out of favor because the market is generally going up. But when the market goes down and suffers a steep bear market, cash is a hot commodity. So are safe stocks resistant to recessions with solid brands and wide moats.

It's no accident that Berkshire Hathaway operates an incredibly stable business chock-full of insurance companies, America's largest railroad, various energy and utility assets, consumer brands, and public equities in Apple, Coca-Cola, and other solid companies.

A glimpse at diversification

The wisdom to not suffer significant losses sounds great on paper. But how does it work in practice? Although nothing is guaranteed in the market, there are steps you can take to limit potential losses and avoid a catastrophic loss.

The most helpful tool is understanding the importance of allocation and correlation. Investing 5% of your portfolio across 20 different fast-growing software stocks may seem like diversification, but chances are those companies are highly correlated and will trade up and down together. A better approach is to pick your favorite companies across multiple spaces/themes and allocate your portfolio to match your risk profile.

The following is a theoretical portfolio for a medium-risk-tolerance investor focused on saving for retirement. It's entirely made up. But it focuses on clear themes and features a predetermined allocation strategy -- with 10% of the portfolio in the highest conviction pick from each category all the way down to 2% for the fourth choice.

If I were to look at this portfolio, I'd say it is balanced and healthy and should do a solid job of following Buffett's lesson to avoid a big loss. Here, we have an investor interested in big tech and the energy transition while also rounding out the portfolio with blue chip stocks, growth stocks, and income stocks.

Notice that some companies could fit into multiple categories. Tesla fits in Big Tech and the energy transition. Microsoft is a big tech stock, a blue chip stock, and a growth stock. The key is to not overly correlate companies and instead gain access to a wide variety of industries.

For example, there's only one energy stock on the list, but it's Chevron, which is a balanced integrated major with a 4.1% dividend yield. It also happens to be Berkshire's fifth-largest public equity holding. So putting a company like that at 10% of the portfolio is reasonable. It would be far riskier to put Rivian at 10% of the portfolio as the top energy transition pick and Tesla at just 2%.

Again, this sample portfolio assumes a somewhat conservative risk tolerance while mixing in some exciting themes. But if you're going to follow Buffett's advice to avoid big losses, then this kind of discipline is necessary.

A lesson you can use today

Buffett deserves credit for practicing what he preaches. Apple makes up 44.3% of Berkshire's public equity portfolio. But that's mainly because the stock has been such a big winner for Berkshire since the company began buying it in 2016.

The public equity portfolio is worth $370 billion of Berkshire's $892 billion market capitalization. Simple math tells us that the Apple stake as a percentage of the value of the whole company is more like 18% -- which is reasonable for a blue-chip growth stock.

Over the last few decades, Berkshire has done well despite being underweight on tech and missing out on some key themes simply because it has avoided big losses and invested in what it understands.

Individual investors don't have to keep a cash hoard on hand in the same way that Berkshire chooses to, but they can implement Buffett's timeless lesson to help compound wealth over time reasonably.