Warren Buffett Warns About Diversifying Your Portfolio

Hey everyone! In this video, we are going to listen to Buffett describe why he recommends serious and knowledgeable investors should ignore conventional wisdom and purposely have a concentrated portfolio of stocks.

Make sure to stick around to the end because you're going to learn how to apply these concepts Warren Buffett lays out to your own investment portfolio. But first, make sure to like this video and subscribe to the channel because it is my goal to make you a better investor by studying the world's greatest investors. Without further ado, let's dive in!

The question is about diversification, and I've got a dual answer to that. If you are not a professional investor; if your goal is not to manage money in such a way as to get a significantly better return in the world, then I believe in extreme diversification. I mean, if so, I believe 98 or 99 maybe more than 99 percent of people who invest should extensively diversify and not trade. So that leads them to an index fund type of decision with very low cost because all they're going to do is own a part of America, and they made a decision that only part of America is worthwhile. I don't quarrel with that at all; that is the way they should approach it unless they want to bring an intensity to the game to make a decision and start evaluating businesses.

But once you're in the business of evaluating businesses, and you decide that you're going to bring the effort and intensity and time involved to get that job done, then I think diversification is a terrible mistake, at any degree. I got asked that question at SunTrust the other day, and if you really know businesses, you probably shouldn't own more than six of them. I mean, if you can identify six wonderful businesses, that is all the diversification you need, and you're going to make a lot of money. I will guarantee you that going into a seventh one, rather than putting more money in your first one, is going to be a terrible mistake. Very few people have gotten rich on their seventh best idea, you know, but a lot of people have gotten rich on their best idea.

Yeah, old mission is way bigger than collation. There are big opportunities in life that have to be seized. We don't do very many things, but when we get the chance to do something that's right and big, we've got to do it. Even to do it on a small scale is just as big a mistake, almost, as not doing it at all. I mean, you've really got to grab them when they come because you're not going to get 500 great opportunities.

You would be better off if when you got out of school here you got a punch card with 20 punches on it. Every financial decision you made, you used up a punch. You'd get very rich because you'd think through very hard each one. I mean, you went to a cocktail party, and somebody talked about a company he didn't even understand what they did or couldn’t pronounce the name, but they made some money last week. Another one like it? You wouldn't buy it if you only had 20 punches on that card.

There's a temptation to dabble, particularly during bull markets in stocks. It's so easy, you know? Easier now than ever because you can do it online. You know, just you click it, and then maybe it goes up a point and get excited about that, you buy another one the next day and so on. You can't make any money over time doing that. But if you had a punch card with only 20 punches, you weren't going to get another one in the rest of your life. You would think a long time before every investment decision, and you would make good ones, and you'd make big ones. You probably wouldn't even use all 20 punches in your lifetime, but you wouldn't need to.

You don't even have to follow the stock market to know that Warren Buffett is hands down the greatest investor of all time. With that being said, you would think that he has made hundreds or thousands of successful investments throughout his illustrious career. But you may have been surprised to learn that Buffett attributes his remarkable investment success to just a limited number of investments. While Buffett's company, Berkshire Hathaway, now owns hundreds of companies and stocks, it wasn't always that way.

When Buffett was younger, he had an extremely concentrated portfolio of stocks. When he was 21 years old, he liked the stock of Geico so much that he put half of his entire net worth into this one stock. Conventional wisdom says that an investor should diversify his or her investment portfolio across many stocks in varying sectors of the economy. Investing textbooks and college finance professors say that risk is reduced by spreading your money among a significant amount of stocks.

Why does Buffett differ in his approach? From my study of Warren Buffett, which includes reading every essay he has written since 1965 and watching every interview he has given, there are four main reasons I point to as to why the strategy of running a concentrated portfolio has worked for Buffett.

The first reason I point to is that Buffett truly views stocks as ownership stakes in businesses and not just pieces of paper that float around in price. Since Buffett truly understands the underlying fundamentals of the business, he is not worried about short-term price fluctuations. That leads me to my second point: Buffett views risk differently than most investors.

Conventional investing wisdom views risk as volatility, or to put it simply, how much a stock price moves up or down. Buffett is different; instead, he defines risk as the likelihood of a permanent loss of investment capital due to deterioration in the underlying performance of the business, not short-term movements in the company's stock price. The third reason is that Buffett invests in companies when there's a high margin of safety.

This means that he's investing in a company only when the price he is paying for a stock is significantly less than the true value of the business. Or, put another way, Warren Buffett only buys a stock when he's getting it at a discount relative to the actual value of the business. This helps him ensure that the probability of his investment being successful is high, meaning he feels more comfortable making a large bet because the likelihood of it working out is high.

The final reason is that Warren Buffett tends to stay away from technology stocks that are susceptible to rapid change due to technology. Because tech companies can easily have their business destroyed due to an unexpected technological shift in society or by a competitor entering the market with a superior technology, the lifespan of a tech company is significantly shorter than non-technology businesses such as a railroad.

This makes large concentrated investments in tech companies very risky because of a higher probability of permanent capital loss. This is why venture capitalists, who mainly focus on technology companies, spread their investments out over a wide range of companies. They know most of their investments will likely fail, but the ones that do work will more than make up for all the ones that do fail.

So now that we understand the logic behind why Buffett recommends a concentrated portfolio, here's one of the best analogies I've ever heard from Warren Buffett when it comes to portfolio diversification. While many professional investors and academics would say an investor needs a lot of stocks in his or her portfolio to be diversified, Buffett strongly disagrees. He uses the hypothetical example of a local businessman.

Imagine a businessman in your hometown. Let's say this businessman owns the local McDonald's franchise, the most successful car dealership in town, some rental properties, and a factory that manufactures a product. Even though this businessman only owns four businesses, wouldn't you say that his wealth is pretty diversified? Of course, you would. So how is it any different with stocks? Since stocks are just partial ownership of a business, Warren Buffett makes the argument that you should focus on your best ideas as opposed to buying stocks you don't like as much for the sake of having a diversified portfolio.

There is another important question that needs to be answered because Buffett is a huge fan of portfolio concentration. Does that mean that everyone should be this concentrated? The simple answer is no. Researching investments is time-consuming. Investors have to filter through hundreds or even thousands of companies to find just a handful they can understand, have strong business fundamentals, and are selling for a reasonable price.

Buffett recommended that people who don't want to put in the work to learn about investing and spend time researching stocks should do the opposite of what he talked about in this clip. Buffett recommends these people broadly diversify. In particular, he recommends investing in an S&P 500 index fund.

The S&P 500 is a stock market index composed of the largest 500 companies listed on stock exchanges in the United States. It is one of the most closely filed equity indices. This means that an investor who puts their money into this index has that money spread out among the 500 largest publicly traded companies in America. This helps ensure that investors aren't overly exposed to any one particular stock but instead own a piece of American business.

While this strategy 100% guarantees that you won't outperform the market, it also ensures that you won't underperform the market. Many investors are perfectly fine with receiving the average return of the S&P 500.

There is one more question you should be asking yourself: Why does Warren Buffett preach portfolio concentration while also owning hundreds of different businesses and stocks through his holding company, Berkshire Hathaway? The reason for this is the size of Berkshire Hathaway's investment portfolio.

When you include cash, the portfolio Buffett manages is approaching $400 billion. This means that Buffett is managing a portfolio the size of the entire annual GDP of countries such as Denmark, Ireland, and Colombia. There just simply aren't enough companies large enough that Buffett can run a concentrated portfolio like he prefers. As a result, the portfolio he manages has become much more diversified than in the past.

Buffett attributes the size of the portfolio to its diminishing return performance. So there we have it! Make sure to like this video and subscribe to the channel. If this video was helpful, talk to you soon!