Warren Buffett: diversification is for ignorant?
If you are an investor you might have heard this word called diversification from time to time. Diversification is allocating your money in different assets such a way that it reduces your investment's exposure to risk. sounds good right? yeah!. but why did Warren Buffet, The Oracle of Omaha say
"Diversification is protection against ignorance and It makes little sense if you know what you are doing"
well, what did he mean by that? we will explain it in this article.
The idea of diversification exists in the first place because if the investor puts all his or her money in a single company or single industry, they might lose all the money if the company doesn't perform well due to some reason so, the ultimate goal of every investor is reducing risk and the investor will build the portfolio accordingly, It is all too easy to say that you would like to follow a reduced-risk strategy, but implementing this goal is the hard part.
here is what Warren Buffet said on 1996 Berkshire Hathway annual shareholders meeting
"If you know how to analyze businesses and value businesses, it's crazy to own 50 stocks or 40 stocks or 30 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 you 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."
By doing your homework(research) you can eliminate the requirement for diversification. In fact, if you are doing your homework, according to Warren Buffet there's no need for diversification at all. Investors should never buy a stock just because they think they should. Every investment should be backed up by research and a solid understanding of the opportunity.
Imagine you are driving your car to work. You know you’ll get to work safely, you’ve done this a million times. Now imagine driving the same route, in the same vehicle, except a 12-year-old is behind the wheel. You probably won’t make it into work today.
The journey and the vehicle for investing are the same. Education and knowledge about the business are the differentiators between good and bad investors.
The thing is diversification is not a wrong strategy but over-diversification is.
Pros of diversification
Reduces the overall volatility of your portfolio and potential risk
When investments in one area perform poorly, other investments in the portfolio can offset losses
An investor who chooses to diversify with investments in foreign stocks can try to put funds into countries experiencing economic booms. Those shares can produce substantial gains at a time when the performance of domestic stocks low
Cons of diversification
If you over-diversify your portfolio, it could lead to average returns.
Diversifying an investment portfolio tends to limit potential gains and produce average results. An investment portfolio of five carefully chosen stocks might produce more returns than a portfolio of 50 stocks.
Rebalancing a diversified portfolio can be complicated and time-consuming.
There is a startup called smallcase which actually solves all those problems. They make constructing your portfolio simpler. It is a platform where orders for varying quantities of multiple stocks can be placed at one click. The company calls its products smallcases, which are essentially baskets of stocks that are prebuilt and you can build one. (THIS IS NOT A PAID PROMOTION), we felt that they really innovative and they solve an actual problem and it would be worth mentioning them)