Diversification is widely considered an investing basic. Personal finance courses teach it as gospel, deriding individual stocks as tantamount to casino gambling. Billionaire investor Warren Buffett famously stated that "You know, we think diversification is—as practiced generally—makes very little sense for anyone that knows what they’re doing...it is a protection against ignorance."
In his view, studying one or two industries in great depth, learning their ins and outs, and using that knowledge to profit from those industries is more lucrative than spreading a portfolio across a broad array of sectors so that gains from certain sectors offset losses from others. In that sense, Buffett doesn't support diversification.
In this article, we look at the concept of diversification and explore what Buffett meant by his quote.
Key Takeaways
- Diversification is an investment strategy that prescribes investing in a series of asset classes, companies, and sectors.
- An investor who diversifies their holdings can minimize their losses and risk.
- Diversification has some downsides such as missing out on potential gains in search of less risk.
- Diversification may also lead to higher transaction fees and an overreliance on a financial advisor for more complex portfolios.
What Is Diversification?
Don't put all your eggs in one basket. That's the basic premise behind diversification. It is a popular investment strategy that tries to mitigate losses by spreading an investor's risk across multiple investments and different vehicles.
Here's how it works. Investors and financial professionals diversify their holdings by investing money in a variety of different investments. This gives them a cushion against risk. The idea behind this is that the positive gains generated by one investment effectively balance out any losses generated by another investment.
You can do this by diversifying your stock holdings to companies in different sectors. You can further diversify your investment holdings—and neutralize stock market risk—by investing in fixed income securities, real estate, and cash. Traders further diversify by selecting investments such as mutual funds and exchange-traded funds (ETFs) from different sectors that follow different trends. Another way they expand their holdings is to look beyond their borders.
With many investors proponents of diversification, why would Buffet suggest the opposite? The following sections are the reasons why diversification may not necessarily be good for everyone.
Don't just invest in one asset class, but if you do invest only in stocks, consider companies that give you exposure to multiple sectors.
Diversification May Reduce Returns
The problem with diversification, in Buffett's view and investors just like him, is although the risk is managed and mitigated by sector gains offsetting sector losses, the opposite is also true. Sector losses offset sector gains and reduce returns.
The part of the quote about how important it is to know what you're doing is something Buffett can speak to with very good authority. That's because Buffett amassed a fortune by acquiring incalculable knowledge about all things finance and about specific companies and industries. He took that knowledge and hand-picked his investments.
An investor who studies trends and has a keen understanding of how different companies and industries react to various market trends profits much more by using that knowledge to their advantage rather than passively investing across a wide range of companies and sectors.
This kind of investor can go long on a company or sector when market conditions support a price increase and exit their long position by going short when indicators project a fall. By doing so, the investor can profit in either scenario. These profits, therefore, are not offset by losses in unrelated industries.
$121.06 Billion
Warren Buffet's net worth as of Sept. 3, 2023.
Diversification May Limit Knowledge
Buffett's perspective is that for individuals who have a strong understanding of specific investments, sectors, or businesses, the need for broad diversification may be reduced. In other words, if you thoroughly know what you're investing in and have confidence in your choices, you may not need to diversify extensively. In other words, diversification protects ignorance because being diversified may imply inherent ignorance in what you're investing in.
Buffet suggests that investors who possess a deep level of knowledge may be better off concentrating their investments in areas they understand deeply, rather than spreading their capital too thin. This is also where diversification may faulter. If a portfolio becomes overdiversified and too complex, an investor may turn to a third-party advisor to manage. In this situation, the investor may continue to become more and more unaware of their holdings and reliant on a broad portfolio strategy in hopes of parts of their portfolio being a winner.
Diversification May Cost More
Diversification involves spreading investments across various assets to reduce risk, but it can lead to higher transaction costs. This occurs due to the increased number of trades needed for diversification, frequent rebalancing to maintain allocation targets, and asset management fees for diversified funds.
In certain contexts, Buffet may be suggesting that diversification doesn't make sense for everyone because some may be able to generate investment returns without having to pay as high of costs. Those who are less experienced may choose to diversify and potential pay higher costs in exchange to reduce their risk. In reality, it may be entirely possible to craft a less risky portfolio with higher earning potential or greater Sharpe ratio calculations for fewer fees by transacting less.
Diversification may be the best strategy for some investors and not the best strategy for others. Discuss the implications of both with a financial advisor to decide which strategy is best for you.
Diversification May Stymie Strategy
Diversification can also limit the implementation of highly tailored investment strategies in several ways. First, it imposes asset allocation constraints by spreading investments across various asset classes, reducing the ability to allocate a substantial portion of the portfolio to a specific strategy or asset class. Though you may have performed vast research on a single industry and feel confident in its future, your diversification strategy limits what you can do here.
Diversification also reduces concentration, making it challenging to focus intensely on specific investments, sectors, or themes. Buffet's quote may hint that just buying a diverse range of securities protects you from having to actually learn anything about those industries. It would be impossible to stay up to date on a heavily diversified portfolio, and Buffet's argument is spreading that risk is one way to not have to learn about your investments.
Last, diversification is said to dilute the best ideas. Investors who have strong conviction about an investment outcome may be better suited to invest entirely in that strategy. Ultimately, it is up to the investor to decide how much risk to take on compared to what their upside return potential is; the more informed their decision and the more pointed their strategy, the less ignorant an investor will be regarding their holdings.
Composition of Buffet's Portfolio
According to HedgeFollow, Berkshire Hathaway's holdings are diversified across roughly 50 securities as of September 2023. Of these, 10 securities hold at least 1% weight of Berkshire Hathaway's assets. As of September 2023, Berkshire Hathaway held at least $1 billion in 21 different securities.
Though this portfolio may sound highly diversified, it may be less concentrated than it may appear. In Berkshire Hathaway's Q2 2023 quarterly external reporting, the company noted that 78% of the aggregated fair value of its investment in securities were concentrated in five companies: Apple, Bank of America, American Express, Coca-Cola, and Chevron. An astonishing 51% of Berkshire Hathaway's portfolio is in Apple. In addition, this concentration has been increasing, as the top five companies made up only 75% of the aggregated fair value at the end of 2022.
What Is an Example of a Diversified Investment?
A diversified investment would be a portfolio that is diversified in multiple asset classes, such as stocks, bonds, real estate, metals, and other assets. The theory behind this is that different asset classes do not correlate to the market in the same manner, so if one or two assets perform poorly, an investor's entire portfolio won't perform poorly. A diversified investment could also be investing in one fund that diversifies its own investments in different assets or if it is one asset, such as stocks, the stocks are in different types of companies and industries.
Why Is Diversification Good?
Diversification is good because it is one of the primary tools for reducing portfolio risk. A portfolio that is diversified is less susceptible to losses than one that is concentrated in only one or two types of investments.
What Are Some Ways to Have a Diversified Portfolio?
Investors can create diversified portfolios in many ways. They can customize the stocks and bonds they invest in, making sure there is diversity among the choices. Within stocks, they can pick companies that have different sizes, different products, different industries, and different regions. Investors can also choose a variety of exchange-traded funds (ETFs) that invest in different areas; for example, one that invests in technology and another in commodities.
The Bottom Line
There's no doubt that it pays to be diversified. Doing so helps manage risk and mitigate losses. As one sector or investment class goes down, these losses should be neutralized by the gains in another. But, as Warren Buffett points out in his famous quote, you won't benefit from this strategy—or any other one, for that matter—if you don't know what you're doing. Knowledge is power, after all. Doing your homework before you begin actively investing will help you realize the returns you seek.
