Warren Buffet said, “Diversification makes very little sense for anyone that knows what they’re doing.” He also said, “Diversification is a protection against ignorance…” Most of us need that protection against ignorance, yet diversification often makes us feel bad when some of our holdings don’t do as well as others. We make the case why we should diversify anyway.
Topics covered include:
- Warren Buffet says it’s crazy to own more than 30 stocks, but Berkshire Hathaway owns 48 stocks
- What does it mean to analyze a business
- How have U.S. stocks performed relative to non-U.S. stocks long-term
- What has driven the outperformance of U.S. stocks and what has to happen for it to continue
- What are examples of diversification plays just in case the U.S. falters
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Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it.
I’m your host, David Stein. Today’s episode, 401. It’s titled “Why diversifying your portfolio feels so awful.” Around the year 2000, two of my institutional clients were a university endowment and a private foundation.
The head of the Investment Committee at the university endowment was an incredibly successful stock picker, who focused on concentrated positions in mostly growth-oriented tech stocks. Meanwhile, the private foundation had 60% of their assets with an incredibly successful hedge fund.
My job as an investment advisor was to help both of these clients diversify into additional asset categories and investment managers. And it wasn’t always easy, because, on the one side, this hedge fund had done incredibly well, and continued to do incredibly well. But what if it didn’t? The client had a significant amount at stake with one manager. The same for the university endowment, if it focused on just investing in a handful of stocks.
Warren Buffett and Diversification
Warren Buffett at the 1996 shareholder meeting for Berkshire Hathaway said, ‘We think diversification as practice generally makes very little sense for anyone that knows what they’re doing. Diversification is a protection against ignorance.
“If you want to make sure that nothing bad happens to you relative to the market, you own everything. There’s nothing wrong with that. That is a perfectly sound approach for somebody that feels like they don’t know how to analyze businesses. If you know how to analyze businesses, it’s crazy to own 50 stocks, 40 stocks, or 30 stocks.”
My role as an institutional advisor was to protect clients from our collective ignorance. We didn’t spend time analyzing individual businesses. Incidentally—I looked—Berkshire Hathaway currently owns 48 stocks, so more than Buffett’s 30 that he thought was crazy to own.
But in Buffett’s defense, the portfolio is very concentrated. The top 10 holdings make up 85% of Berkshire’s stock portfolio, and its single largest holding, Apple, makes up 38% of its portfolio.
What does it mean though to analyze a business, as Buffett suggests? It means to determine its value, what it’s worth, to go through the financials, to go through the prospects. This is what investment managers do—they try to determine the value of a company on a per-share basis, and then they purchased the stock if they believe a business is worth more on a per-share basis than what the consensus values the business at, the consensus being whatever the current stock price is. If the business analysis suggests the stock is worth more than its trading today, then it should be bought.
When an investor does that, buys a stock that they believe it’s mispriced, they’re saying the consensus is wrong (even though thousands of other investors, many of which have analyzed the businesses and decided it was worth closer to what they paid for the stock) but that other things will happen to help the stock go higher.
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