Warren Buffett (Trades, Portfolio) has provided some valuable insight regarding diversification. His views stem from Ben Graham's comments in "The Intelligent Investor," which function not on the investors' ability, but the investors' time available to dedicate to the activity of investing.
What are your views on diversification?
"I have two views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.
"If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your first choice. 'Lebron James analogy.' If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.
"Charlie and I operated mostly with five positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express (AXP, Financial) after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30-year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.
"Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.
"In stocks, it’s the only place where, when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonald's (MCD, Financial) reduces the price of hamburgers, I think it’s great."
I believe his Lebron James analogy is great. When you have great companies in your portfolio (and their prospects continue to look good), there is no reason to reduce their impact by adding other names which are not likely to produce the same levels of return. I believe it is critical that as investors we rely on the concept of opportunity costs; in this way, we will always be thinking about our second-best options and their impact to our returns.
Also, it is very important to highlight the relevance of having flexible ranges (as well as cash) to operate and load up on a holding when necessary. As Charlie Munger (Trades, Portfolio) says, the occasion is rare where we find something so attractive that requires all of our diligence and effort. When opportunities like that come across, it is critical not only to be able to recognize them but also to swing for the fences as needed.
What do you think of Buffett's advice?
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