Warren Buffett has said diversification is protection against ignorance. And he’s right! But his actions show that he accepts his ignorance. You can learn a lot by listening to great minds of our time but you’ll learn more by watching what they do.
In Buffett’s case, he has a widely diversified portfolio. His holding company, Berkshire Hathaway, owns stock in airline, banking, oil, and technology companies. And it doesn’t stop there. Berkshire owns Geico, See’s Candies, BNSF Railway, Fruit of the Loom, and many other companies.
So, don’t draw the wrong conclusion when you hear Buffett’s quote…
Warren Buffett Accepts his Ignorance
Ignorance is the lack of knowledge or information. And since we’re not all-knowing, we’re all ignorant to some degree. Even when someone takes decades to learn a topic, there’s still gaps in knowledge.
When it comes to a large business, there are thousands of moving parts. Even if you research a business for decades – or help manage the company – you can still miss vital information.
For example, Enron auditors and even the board of directors missed seeing billions of dollars in losses. Jeffrey Skilling and other executives used shady accounting tricks to hide failed deals and projects. Enron had just over $100 billion in sales in 2000… but filed for bankruptcy the next year.
No matter how well you think you know a business, there’s always risk. You might overlook important information or someone might withhold it. This is one powerful reason you shouldn’t put all of your eggs in one basket.
When it comes to risk, I always remind myself of the follow table…
|Investment Loss||Gain to Breakeven|
The bigger the loss, the larger the gain required to get back to where you started. For example, if you lost 90%, it would take a 900% gain to reach breakeven. And a 900% gain doesn’t come around too often. With this in mind, let’s look at how diversification helps lower the risk of big losses.
How Diversification is a Hedge Against Ignorance
If you own a basket of investments and one tanks, the other assets can help you stay afloat. This is true as long as the investments aren’t perfectly correlated. And the less correlated, the larger the diversification benefit.
Let’s say you own a small property worth $50,000. And on top of that, you invest another $50,000 in your favorite company. But over the coming year, a fire demolishes the property. And since it’s uninsured, it’s a complete loss… but on the upside, the company shares are up 10%.
Overall, your starting $100,000 is down to $55,000. That’s better than a 100% loss if you stuck it all into upgrading the property. Now, this is a simple two asset portfolio. But as you add more assets, you can further limit losses.
Benefits of Diversification Dwindle
It’s great to diversify but if you own hundreds of assets, it can be a hassle to manage. Fees, taxes, and other expenses can add up. So, more isn’t always better.
On top of that, the benefits of diversification drop as you add new positions. There’s some fancy math to back this up and I could go into great detail – thanks to my finance degree and passing the CFA exams – but I’ll save you the time. Instead, this chart sums up the benefits…
With each new holding added, the standard deviation drops less. It’s approaching a limit that helps mark where systematic and unsystematic risk meet.
Now a great question… how many assets is too many? If you aren’t piling everything into the same sector, the rule of thumb is no more than 20. And some of the world’s best investors concentrate their portfolios in 10 or fewer positions at one time.
The Big Takeaway from Buffett’s Quote
Warren Buffett uses diversification to protect against ignorance. All of the world’s top investors do the same. Although, Buffett isn’t as diversified as his portfolio appears.
Modern Portfolio Theory (MPT) suggests adding a higher portion of bonds, alternative investments, and other assets. This can increase your total risk adjusted return in the short-term… but long-term investors know stocks have better risk adjusted returns in the long-run (10+ years).
As a result, the majority of Buffett’s wealth is tied up in the stock market. And on top of that, Berkshire Hathaway’s top 10 positions make up more than 80% of the total portfolio. This strategy has clearly worked and has helped Buffett become one of the world’s best investors.
Now, since I also have a long-term investment horizon, I’ll follow Buffett’s lead. After the next market correction, I plan on boosting my stock asset allocation close to 100%. And I’ll keep my portfolio manageable with 10-20 companies.
In summary, I’ll continue to seek out and read insight from great investors… but always with a grain of salt. Ultimately, actions speak louder than words. So, follow the money if you want real answers. Money is simply a measuring stick of value.