When it comes to the concept of diversification, there exist two distinct schools of thought. Some argue that diversification is an inefficient allocation of resources, while others advocate for a broad and varied approach to portfolio building. Conventional wisdom dictates that investors should spread their capital across numerous stocks representing diverse sectors of the economy, with investment textbooks and university finance professors emphasizing that risk diminishes as one diversifies holdings.
However, luminaries in the world of investing, such as Warren Buffett, George Soros, William J. O'Neil, and Bernard Baruch, have extolled the virtues of maintaining concentrated positions. Buffett, for instance, once remarked, "Diversification is a safeguard against ignorance," asserting that it holds little merit for those who possess a deep understanding of their investments.
Bernard Baruch echoed this sentiment, stating, "It is unwise to disperse one's resources among an excessive number of distinct securities," citing the need for constant vigilance to stay informed about factors affecting a security's value. According to him, one can master the intricacies of a few select investments, but attempting to do so for a multitude of holdings is impractical.
Of course, the selection of stocks for a concentrated portfolio demands thorough analysis and unwavering attention. An investor committed to a concentrated approach must invest significant effort and acquire comprehensive knowledge about their chosen investments. This entails active participation in earnings conference calls, meticulous examination of financial data, and vigilant monitoring of the business landscape.
How Warren Buffett started investing?
Warren Buffett's journey into investing commenced at the age of 11 when he made his initial foray into the world of finance. He purchased three shares of Cities Service Preferred at a price of approximately $38 per share. While he did eventually sell these shares at $40 each, thereby realizing a modest profit of $2 per share, a significant lesson in patience was imprinted on his young mind when the stock's value later surged to $200 per share.
By the time he turned 21, Buffett had developed a profound liking for GEICO's stock, to the extent that he allocated half of his entire net worth to this single investment. But what was his motivation for such a bold move? Understanding his distinctive approach is crucial.
Buffett adopted a method akin to Phil Fisher's Scuttlebutt approach. He believed in acquiring an exhaustive understanding of a company before committing a substantial investment. His strategy involved meticulous examination of a company's history and strategic direction. He was known for conducting thorough investigations and making deliberate, infrequent decisions. Once he held shares in a company, he displayed a reluctance to part with them. A prime example of this was his initial significant investment in GEICO, where the young investor spent an entire day engaging in discussions with the future CEO of the company. By the end of that conversation, he had gained an exceptional insight into the business, providing him with the confidence to take a substantial position in the company.
Warren Buffett never liked the idea of too much diversification
Warren Buffett has long held a disdain for excessive diversification. A quick glance at Berkshire Hathaway's portfolio at the close of the first quarter of 2021 reveals approximately 50 positions, a relatively modest number compared to other investment firms that may boast four or even five times that amount. To Buffett, diversification serves as a safeguard against ignorance.
When your portfolio encompasses just three stocks, the risk and profit potential are more pronounced. Conversely, when your portfolio swells to fifty stocks, both risk and expected profitability tend to diminish. This phenomenon occurs because over diversification can lead to the profits and losses of various stocks offsetting one another, ultimately reducing the overall profitability of your portfolio.
Warren's investment philosophy is well-illustrated by Berkshire Hathaway's publicly listed portfolio, where a staggering 45% of holdings are concentrated in Apple. This exemplifies the notion that when you possess unwavering confidence in a particular stock and it aligns with your investment criteria, it's financially prudent to allocate a significant portion of your capital to that choice. The focus should be on your best investment idea, not the third or fifth in line. Once you've attained a certain level of knowledge, diversification becomes a declaration of risk aversion rather than risk neutrality.
A more judicious approach, according to Buffett's principles, involves selecting two high-quality stocks from each sector and investing strategically based on prevailing market conditions. For instance, consider investing in fertilizer companies during the monsoon and sowing season, focusing on the financial sector and auto industry during festive periods, and maintaining positions in FMCG and pharmaceuticals year-round. The key lies in a thoughtful analysis of your risk tolerance before making investment decisions. It's wise to avoid exposing yourself to unforeseen risks solely for the sake of diversification.
How is Warren Buffett diversified?
Warren Buffett's concept of diversification might appear unconventional when compared to contemporary investment strategies. He defines diversification as a portfolio comprising 50% of its assets in just five stocks and another 30% in approximately 15 stocks. In today's context, such a concentrated portfolio would be perceived as intensely focused, lacking diversification. Buffett critiques what he refers to as "over-diversification," a practice in which fund managers buy a hundred or more stocks, resulting in mediocre returns that often fall below the market average due to management fees.
Based on my extensive study of Warren Buffett, including the scrutiny of every essay he has penned since 1965 and analysis of all his interviews, I've identified four key reasons behind the success of his concentrated portfolio strategy.
Firstly, Buffett perceives stocks as actual ownership stakes in businesses, not mere pieces of paper subject to short-term price fluctuations. His profound understanding of a business's underlying fundamentals allows him to remain unfazed by transient market movements.
Secondly, Buffett's perspective on risk diverges from conventional norms. While conventional wisdom equates risk with volatility or the magnitude of stock price fluctuations, Buffett defines risk in terms of the potential for a permanent loss of investment capital stemming from a decline in a business's fundamental performance, rather than temporary fluctuations in stock prices.
The third reason revolves around Buffett's insistence on a high margin of safety. He invests in companies only when the stock price represents a substantial discount relative to the true value of the business. In essence, he buys stocks when they are priced well below their intrinsic worth. This approach increases the likelihood of a successful investment outcome, enabling him to confidently make substantial bets.
Lastly, Buffett tends to steer clear of technology stocks that are vulnerable to rapid changes in the technological landscape. Given the susceptibility of tech companies to being disrupted by unforeseen technological shifts or the entry of superior competitors, their lifespan is significantly shorter compared to non-technology businesses, like railroads. Consequently, large, concentrated investments in tech companies carry higher inherent risks, owing to the greater likelihood of permanent capital loss. Venture capitalists, who primarily focus on technology firms, opt for broad diversification because they acknowledge that most of their investments may fail, but the ones that succeed will more than compensate for the failures.
How many stocks should a person own?
The number of stocks an individual should include in their portfolio is a critical consideration. Excessive diversification can indeed mitigate risk, but it can also dilute profit potential. Over-diversification occurs when the reduction in expected returns outweighs the benefits of lowered risk. Therefore, investors should aim for a balanced approach to diversification, avoiding the pitfalls of overdoing it while still reaping its advantages.
It's essential to bear in mind that an excessively diversified portfolio may indeed reduce potential returns, but it also diminishes overall risk. As such, for new investors, a prudent strategy might involve initially constructing a portfolio comprising 30 to 35 stocks, with relatively lighter weightage assigned to each stock. As one gains experience over time, it becomes feasible to gradually reduce the number of holdings and transition to a more focused portfolio consisting of 10 to 20 carefully selected stocks.
Ultimately, the key to determining the appropriate number of stocks in your portfolio lies in your ability to effectively manage them. The investor's capacity to stay informed and make informed decisions about their holdings should dictate the extent of their diversification. Whether it's a portfolio of 30 stocks or 1,000, the key is to manage it with diligence and expertise.
Conclusion
In conclusion, the art of diversification in investment lies at the intersection of risk management and profit potential. While over-diversification can reduce risk, it may also dilute the potential for substantial gains. Striking the right balance is essential, and this balance often evolves with an investor's experience and capacity to manage their holdings effectively.
Starting with a moderately diversified portfolio and gradually refining it as one gains expertise is a prudent approach. The ultimate goal is to construct a portfolio that reflects a well-informed and confident investment strategy, even if it consists of a more concentrated selection of stocks. The number of stocks an individual should hold should align with their ability to stay informed, make strategic decisions, and, above all, achieve their financial goals.
In the world of investing, there is no one-size-fits-all answer regarding the ideal number of stocks to own. What matters most is thoughtful consideration of one's risk tolerance, investment objectives, and capacity to manage their chosen holdings. Diversification should serve as a tool to enhance an investment strategy, not an end in itself.
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