When it comes to investing, various strategies and principles are often preached, with diversification being one of the most popular. The idea is simple – spreading investments across a wide range of stocks to reduce risk. However, two of the world’s most respected and successful investors offer a different perspective. Known for their contrarian viewpoints and their uncanny knack for consistently generating profit, these investment titans challenge conventional wisdom and encourage investors to adopt a more focused approach. This article explores their unique perspective and the principles they attribute their success to in their own words. I hope their talk gives you a fresh lens through which to view your investment strategy.
Buffett and Munger Examine Diversification
Below is a transcript of Warren Buffett and Charlie Munger answering a question about diversification at the 1996 Berkshire Hathaway annual meeting.
“My name is Mark. Hey, I’m from Scottsdale, Arizona, and I am very interested in your policies on diversification and also how you concentrate your investments. I’ve studied your inner reports going back a good number of years and there’s been years where you had a lot of stocks in marketable equitable securities portfolio, and there was one year where you only had three, in 1987. So I have two questions: given the number of stocks that you have in the portfolio now, what does that imply about your view of the market in terms of is it fairly valued that kind of idea? And second of all, whenever you take a new investment, you never take less than about 5% and never more than about 10% of the total portfolio with that new position, and I wanted to see if I’m correct about that.”
Warren Buffett replies, “Yeah, well, on the second point, that really isn’t correct. We have positions which you don’t even see because we only listed the ones above 600 million in the last report, and obviously, those are all smaller positions. Sometimes it’s because they’re smaller companies and we couldn’t get that much money in. Sometimes it’s because the prices moved up after we bought them, sometimes it’s because we may be selling the position down even. But so we have no, there’s nothing magic. We like to put a lot of money in things that we feel strongly about, and that gets back to the diversification question.”
“We think diversification, as practiced generally, makes very little sense for anyone that knows what they’re doing. Diversification is a protection against ignorance. I mean, 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 who does not feel they know how to analyze businesses. If you know how to analyze businesses and value businesses, it’s crazy to own fifty stocks or forty stocks or thirty stocks probably, because there aren’t that many wonderful businesses that are understandable to a single human being in all likelihood.”
“And to have some super wonderful business and then put money in number 30 or 35 on your list of attractiveness and forego putting more money into number one just strikes Charlie and me as madness. And it’s conventional practice, and it may, you know, if all you have to achieve is average, it may preserve your job. But it’s a confession in our view that you don’t really understand the businesses that you own.”
“You know, on a personal portfolio basis, I own one stock. But it’s a business I know, and it leaves me very comfortable. So, do I need to own 28 stocks in order to have proper diversification? That would be nonsense. And within Berkshire, I could pick out three of our businesses, and I would be very happy if they were the only businesses we owned and I had all my money in Berkshire. Now I love the fact that we can find more than that and that we keep adding to it. But three wonderful businesses is more than you need in this life to do very well.”
“And the average person isn’t going to run into that. I mean, if you look at how the fortunes were built in this country, they weren’t built out of a portfolio of 50 companies. They were built by someone who identified with a wonderful business. Coca-Cola is a great example. A lot of fortunes have been built on that. And there aren’t 50 Coca-Colas; there aren’t 20. If there were, we could all go out and diversify like crazy among that group and get results that would be equal to owning the really wonderful one. But you’re not going to find it, and the truth is, you don’t need it.”
“I mean, if you have a really wonderful business, it’s very well protected against the vicissitudes of the economy over time and competition. I mean, we’re talking about businesses that are resistant to effective competition. And three of those will be better than a hundred average businesses. And they’ll be safer, incidentally. I mean, there is less risk in owning three easy-to-identify wonderful businesses than there is in owning 50 well-known big businesses. And it’s amazing what has been taught over the years in finance classes about that. But I can assure you that I would rather pick, if I had to bet the next 30 years on the fortunes of my family that would be dependent upon the income from a given group of businesses, I would rather pick three businesses from those we own than own a diversified group of 50.”
Charlie Munger adds, “Yeah, what he’s saying is that much of what is taught in modern corporate finance courses is twaddle.” [Applause]
Buffett interjects, “Do you want to elaborate on that, Charlie?”
Munger continues, “You cannot believe this stuff. I mean, it’s Modern Portfolio Theory.”
Buffett adds, “And it has no utility. It will tell you how to do average, but I think anybody can figure out how to do average in fifth grade. It is just not that difficult, and it’s elaborate, and there’s lots of little Greek letters and all kinds of things to make you feel that you’re in the big leagues, but there is no value added. I have great difficulty with it because I am something of a student of dementia. I can classify dementia in some theory structure or models, but the Modern Portfolio Theory, it involves a type of dementia I just can’t even classify. Something very strange is going on.”
Buffett continues, “If you find three wonderful businesses in your life, you’ll get very rich. And if you understand them, bad things aren’t going to happen to those three. I mean, that’s the characteristic of it.”
Munger concludes, By the way, maybe that’s the reason there’s so much dementia. If you believe what Warren said, you could teach the whole course in about a week.”
Buffett sums up with, “Yeah, and the high priest wouldn’t have any edge over the laypeople, and that never sells well.”
- Investment concentration is often a hallmark of successful portfolios, as it indicates a high level of confidence and understanding in the selected businesses.
- Diversification is often seen as a safeguard against ignorance; however, it can be unnecessary for those who have mastered business analysis and valuation.
- The conventional practice of holding a large number of stocks can sometimes be a sign of inadequate understanding of the businesses owned.
- Great fortunes are often built on a few excellent businesses rather than a wide array of average ones. Examples like Coca-Cola underscore this principle.
- Strong businesses with effective resistance to competition offer better returns and security than a broad selection of well-known big businesses.
- Contemporary teachings in finance courses, especially Modern Portfolio Theory, often overcomplicate the simple principle of investing in a few great businesses.
- Identifying and understanding a few outstanding businesses is a more profitable and secure strategy in the long term.
In the financial world, Warren Buffett and Charlie Munger offer an unconventional yet successful perspective on diversification. They advocate for concentrated investment in a few well-understood businesses rather than a widespread portfolio of numerous stocks. This approach, they argue, reflects a deeper comprehension of one’s investments and can potentially yield greater returns. Their view challenges conventional wisdom and typical teachings in finance, particularly the Modern Portfolio Theory. While diversification is widely promoted as a means to mitigate risk, Buffett and Munger argue that investing in a small set of extraordinary businesses that are well insulated from competitive threats and economic fluctuations can lead to richer rewards. Hence, the essence of successful investing lies not in the quantity of stocks held but in the quality of a few carefully selected investments.