Warren Buffett (Trades, Portfolio) is one of the greatest and most experienced investors of all time. I encourage anyone who has not read his historical letters or Berkshire Hathaway’s transcriptions (BRK.A, Financial) (BRK.B, financial) annual meetings to do this.
However, I also encourage investors to ignore many of the quotes from Buffett that they read online. Most of them are taken out of context, and articles rarely explain why the Oracle of Omaha made these comments in the first place. Buffett’s diversification analysis is one example.
Misleading use of Buffett’s quotes
Two of Oracle’s comments are widely publicized on diversification. They are “We think that diversification, as practiced in general, makes very little sense to anyone who knows what it does” and “Diversification is a safeguard against ignorance”.
These comments are essentially the same. They were almost part of the same sentence. At the Berkshire meeting in 2004, Buffett made these comments one after the other in a much longer discussion of diversification. To really understand what he meant, we also need to consider the following part of Buffett’s statement:
“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. I mean, it’s a perfectly healthy approach for someone. one who doesn’t think he knows how to analyze companies. If you know how to analyze companies and value companies, it’s crazy to own 50 stocks or 40 stocks or 30 stocks, probably, because there isn’t a lot of wonderful businesses that are understandable to one human being, in all likelihood. And have a super wonderful business and then put money at number 30 or 35 on your attractiveness list and forgo putting more money at number one , that sounds crazy to me, Charlie and I. “
The key element of this statement is understanding how to analyze a business. If you know how to analyze a business and the business is part of your skillset, then owning other businesses just for the fun of it doesn’t make sense.
However, diversification can be acceptable if one does not understand how to analyze the business or the sector in which the business operates. Maybe it’s even better to hold the whole deal and forget about it. This is the differentiator – business analysis. This is why it can be dangerous to take the Oracle’s comments on diversification out of context.
If one read the statement “We think that diversification, as practiced in general, makes very little sense to anyone who knows what they are doing,” one might think that the best strategy is to own a handful of individual businesses. . But if one really knows what they are doing, and knows the limits of their own investment knowledge, then one won’t take that risk. Indeed, I could argue that diversification makes a lot of sense for investors who know their limits.
A good strategy
In this case, diversification does not protect against ignorance. Diversification is a good investment strategy for investors who are emotionally intelligent enough to know where the limits of their knowledge lie. This is why the isolated use of these quotes and all of Buffett’s other quotes can be downright dangerous.
In this situation, using the quotes in isolation can not only be dangerous, but they are also totally misleading. They paint the opposite picture of what Buffett was trying to convey. The only way to get around this problem is to do your research. Like so much in investing, there is no simple answer to a question. It takes time and effort to find the right solution.
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