When it comes to investing, it seems that everyone wants to minimize risk. They want great returns but don’t want to lose anything while trying. And they’re even asking billionaires like Warren Buffett and Donald Trump for their secrets on how to do just that.
Well known financial writers like Suze Orman - and, ironically, most financial bloggers as well - claim you need to diversify to reduce your investment risk. If you don’t, they say, you could lose money.
But many wealthy people, including Warren Buffett (one of the wealthiest men in the world) say that when intelligent investors diversify, they WILL lose money.
We think diversification, as practiced generally, makes very little sense for anyone who knows what they’re doing. Diversification serves as protection against ignorance.
-Warren Buffett, at Berkshire’s 1996 Annual Meeting
If you are afraid of losing money, then you obviously don’t know what you’re doing. And, if you don’t know what you’re doing– why are you investing in the first place?
I think the big picture here is that the average investor is not very confident about their investment decisions. This is often because they don’t spend a lot of time researching and investing potential investments before they put their hard earned money on the line.
We are all busy people, but ironically many of us take shortcuts when it comes to investments. Often people spend years earning the money that is in their retirement accounts but will spend an hour, or sometimes just a few minutes before deciding where to invest that nest egg. How can you not be apprehensive about such an investment when it was made so callously?
A different approach to this would be to focus the investments you make on market sectors that you are already familiar with. For example, if you have experience working in restaurants, you should consider investing in restaurant or foodservice companies because you already have a baseline understanding about how that industry works and can perform a more educated analysis of restaurants based on your experience.
If you are a pharmacist, then you might want to consider investing in pharmaceutical and biotechnology companies because you already have a background in the industry and know more about it than the average investor.
Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice.
–Peter Lynch, from “One Up On Wall Street”
The big picture idea here is that you should not put your money on the line for an investment if you don’t understand the business or are not familiar with the industry. The most successful investors spend a great deal of time researching possible investments and often stick to industries they are familiar with, and not just the latest buzz they hear about on CNBC.
Warren Buffett says that if you can truly recognize a good investment, diversifying is not a good idea. Or, as Donald Trump might say, it’s “for losers”.
According to Benjamin Graham’s principles, if you can find an investment with a sufficient margin of safety, then you are virtually guaranteed to earn a profit. By this logic, Buffett reasons that you should wait until you understand and analyze all of the information to make a potential investment. And when you do, you should jump in with both feet.
The main mistakes we’ve made , some of them big time, are: 1) Ones when we didn’t invest at all, even when we understood it was cheap; and 2) Starting in on an investment and not maximizing it.
–Warren Buffett, May 2004
December 5th, 2005 at 11:32 am
Thanks for your comment on my website.
The key in the Buffett quote is “for anyone who knows what they are doing”. Unfortunately, most people don’t. Diversification and portfolio balancing prevents investors from chasing performance and buying low and selling high. It allows compounding to do its magic. In another quote Buffett also said “Rule # 1: Don’t lose your money”.
It boils down to this: A cheap, well-diversified portfolio will make market returns with less risk. Warren Buffett’s run rate is about 12% more than that. If anyone can beat market returns (after taxes), they should. Even a small outperformance of the market will provide spectacular returns. I am just not convinced that most average investors can.
December 5th, 2005 at 11:38 am
I absolutely agree. The key is that they must know what they’re doing.
But, I made that point in this post - if you are going to invest your money, shouldn’t you know what you’re doing?
December 6th, 2005 at 10:47 pm
There are plenty of people who select an asset allocation, buy index funds and rebalance once in a while. They make market returns and don’t spend hours analyzing securities.
My only question to active investors is this: How is your portfolio performing against your benchmark, this year, last 3 years and the last 5 years? If they are not beating their benchmark by at least 2%, why are they even bothering?
My guess is most investors don’t benchmark their performance. Most active investors also badly lag their benchmarks (as many academic studies have pointed out). That is why for most investors, not diversifying is a terrible idea.
December 23rd, 2005 at 7:24 pm
The maximum return from an equity stock trading system is when the percent allocated to any one position is about 7.5%. Returns are lower as the allocation declines to a mutual fund style positioning of 1-2% i.e 50-100 positions. The benefit of 1-2% positions is that the drawdowns tend to be lower, though the returns can be 25-50% lower for the same system.
For investing, use 2% positions. For several performance trades, use 5% positions, and leave some in cash or a convservative fund. Never have more than 7.5% in any stock regardless of performance sought.
December 24th, 2005 at 12:15 am
You said to “never have more than 7.5% in any stock regardless of performance sought.” Why?
I’m not a fan of hard and fast rules, especially ones that seem arbitrary.
If you have the foresight to pick a 50-bagger, why should you only invest 2% of your portfolio in it?
May 15th, 2007 at 9:23 pm
i guess it boils down to having the conviction that you’re right.
a lot of people will buy a stock. it’ll go down 20%, and then they’ll bail on it - only to watch to quadruple!
if it was such a good stock at say $100, it should be better at $80, right? unfortunately most people blindly buy a stock because its gone up in the past month or year. They don’t have any idea if its going to continue the way and what the risk factors are.
May 15th, 2007 at 9:30 pm
I absolutely agree with you. This is a perfect example of it; this happened to me not too long ago:
http://www.wealthjunkie.com/2006/06/08/five-mistakes-made-by-newbie-stock-investors-part-one-they-buy-after-the-price-rises/
January 31st, 2008 at 8:17 pm
The best analagy regarding diversification I have ever seen or read went something like this:
You are the owner of a successful business that you understand and that provides you with a wonderful income. Would it not make sense that you would then need to purchase 4 or 5 or 20 more businesses, that you know less about, in order to reduce your risk?
Absolutely not, correct?
Why then, would that apply to your stock picks?
January 31st, 2008 at 9:37 pm
I agree 100%! And that’s the big difference between Warren Buffett and the typical investor. Buffett views owning shares and owning part of a business, most other investors view it completely differently.