Why does Warren Buffett advise against portfolio diversification? What’s the problem with diversifying your investments? How does diversification hurt your return on investment?
Portfolio diversification is a sacred cow in the world of investing. However, the world’s most successful investor, Warren Buffett, scorns the idea of diversifying your portfolio to protect against risk.
Keep reading to learn about Warren Buffett, diversification, and why it’s better to have skin in the game.
Warren Buffett on Portfolio Diversification
According to Warren Buffett, diversification originates from academic models that equate risk with volatility and use diversification as a means to minimize the total volatility in your investments. As in EMT, this theory takes nothing into account except stock price—if a good company’s stock were to suddenly drop, this mode of thinking would label it risky and tell you not to buy it. Buffett defines risk as the odds of suffering financial harm and says the best way to avoid it is to put most of your money on a few safe bets—companies with good management and excellent long-term economics, no matter their short-term stock fluctuations.
(Shortform note: Portfolio diversification is a strategy of investing in a wide assortment of assets with the assumption that even if some go down in value, the ones that go up will offset your losses. In I Will Teach You to Be Rich, Sethi offers a general template for diversifying your portfolio. Investing in index and mutual funds brings with it automatic diversification, because those funds’ value depends on the performance of a multitude of assets. The problem with diversification is that while it offers the psychological value of reducing risk, it reduces your overall return on investment because weak assets undercut the value of those that do well.)
A glance at Berkshire Hathaway’s diversified holdings may make it look like Buffett doesn’t take his own advice. However, several factors must be noted. 1) As a holding company, Berkshire has far too much money to invest in only one place. 2) Most of its investments are in the form of majority shares in the businesses it owns—when Berkshire buys into a company, it commits a significant amount of capital instead of merely buying a few stocks as a hedge against market volatility. 3) Though Berkshire’s investments are widely diversified, Buffett’s personal holdings are not. Nearly all of Buffett’s wealth is in the form of Berkshire Hathaway stock.
(Shortform note: Warren Buffett’s investment advice regarding portfolio diversification is echoed by mathematician Nassim Nicholas Taleb in his book Skin in the Game, in which he presents an ethical argument for concentrated investing as opposed to diversification. Taleb claims that those who get rich by risking their wealth in creative endeavors—such as building a prosperous business—also enrich society as a whole, while those who minimize their risk as wealth increases aren’t motivated to add value back to the world. They simply ride on the coattails of others.)
Why Warren Buffett Is Against Diversification
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Here's what you'll find in our full The Essays of Warren Buffett summary:
- A glimpse into the mind of a man who disagrees with the typical Wall Street mogul
- Buffett's simple yet difficult insights on investing
- Why some of the most widely accepted economic practices are wrong
FAQs
Diversification May Limit Knowledge
What does Warren Buffett say about diversification? ›
My biggest investing mistake is encapsulated in a Buffett quote that many investors take too literally. "Diversification is protection against ignorance," Buffett said. "It makes little sense if you know what you are doing."
Which famous investor is against diversification? ›
Portfolio diversification is a sacred cow in the world of investing. However, the world's most successful investor, Warren Buffett, scorns the idea of diversifying your portfolio to protect against risk.
What is the issue with over diversification? ›
Over diversifying your portfolio reduces the magnitude of gains you could have from the good funds in your portfolio (since to invest in many funds, you'll be investing less in each fund). To put it another way, with wide diversification, you will not lose much, but you do not stand to gain much, either.
Who said diversification is the enemy of performance? ›
Munger, who's called excessive diversification the enemy of exceptional returns, limited Daily Journal's stock portfolio to eight companies or fewer during his roughly 13 years running it.
Do billionaires diversify? ›
They don't diversify their investments right away.
But as the wealthiest people build their net worth, they often go all-in on their own projects, and then diversify as they start earning more.
Is diversification good or bad in business? ›
Diversification is important because it helps a business spread its risk across different areas, reducing dependency on a single market or product. It can also lead to increased revenue streams and improved long-term sustainability.
Who is the number 1 investor in America? ›
Warren Buffett is often considered the world's best investor of modern times.
Who is the smartest investor? ›
Warren Buffett is widely considered the greatest investor in the world. Born in 1930 in Omaha, Nebraska, Buffett began investing at a young age and became the chairman and CEO of Berkshire Hathaway, one of the world's largest and most successful investment firms.
What is the most diversified stock? ›
(NASDAQ:WBD) is one of the best diversified stocks to invest in.
- 3M Company (NYSE:MMM) Number of Hedge Fund Holders: 62. ...
- Comcast Corporation (NASDAQ:CMCSA) Number of Hedge Fund Holders: 63. ...
- Johnson & Johnson (NYSE:JNJ) Number of Hedge Fund Holders: 81. ...
- Exxon Mobil Corporation (NYSE:XOM) ...
- The Walt Disney Company (NYSE:DIS)
Diversifying your business can also bring about some challenges, such as higher costs for research and development, marketing, production, distribution, and management. Additionally, you may lose focus on your core business and customers, or face conflicts between different businesses or segments.
Why did diversification fail? ›
“One of the main reasons that diversification fails is because businesses do not have the right strategy in place,” Shipilov said. “They must think carefully about what distinct resources or capabilities they can move between different markets to give them a competitive advantage.
Why is diversification the riskiest? ›
This is because a diversified portfolio is optimized to achieve the highest risk-adjusted returns, and not the highest absolute returns possible. Thus, diversification may cause an investor to miss out on the potential high returns of a specific stock, asset class, or market segment that is outperforming.
Is too much diversification bad? ›
Too much diversification can make a portfolio worse
Because of that, investors should avoid over-diversifying their portfolio since it waters down their returns too much.
Does diversification reduce gains? ›
What diversification does is reduce volatility. Diversification does indeed smooth out investment returns, but that's a psychological decision, not an investment decision. As a result, asset allocation diversification does not help investment performance, it hurts it.
What are the 4 pillars of value investing? ›
In summary, The Four Pillars of Investing is an important tool for investors looking to design a more successful investment portfolio. Investors can make better financial decisions by comprehending the four pillars of theory, history, psychology, and business.
What investment strategy does Warren Buffett use? ›
What is Warren Buffett's Investing Style? Warren Buffett is a famous proponent of value investing. Warren Buffett's investment style is to “buy ably-managed businesses, in whole or in part, that possess favorable economic characteristics.” We also look at his investment history and portfolio.
What is Warren Buffett's top investing rule? ›
Rule 1: Never lose money.
By following this rule, he has been able to minimize his losses and maximize his returns over time. He emphasizes this so much that he often says, “Rule number 2 is never forget rule number 1.”
Is Berkshire Hathaway a diversified investment? ›
Berkshire Hathaway has a long history of producing market-beating returns. Buffett's diversified holding company now faces some unique challenges because of its enormous size, however.
What investments does Warren Buffett recommend? ›
Warren Buffett made his fortune by investing in individual companies with great long-term advantages. But his top recommendation for anyone is to buy a simple index fund. Buffett's recommendation underscores the importance of diversification.
