In spite of being young, he was certainly wise in his remarks.
In this 1966 Letter to Shareholders' excerpt, Warren Buffett (Trades, Portfolio) provided his views on diversification, and we could see that, even at a young age, he was able to go against the tide and take on contrarian views not only on the market but also in how he built his portfolio.
"We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least 10 percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, 'How much do I put in No. 1 (ranked by expectation of relative performance) and how much do I put in No. 8? This depends to a great degree on the wideness of the spread between the mathematical expectation of No. 1 versus No. 8.' It also depends upon the probability that No. 1 could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have .05 chance of performing 15 percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.
"The above may make the whole operation sound very precise. It isn't. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.
"There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing 100 stocks (whether the manager is handling $1,000 or $1 billion) is not being operated logically. The addition of the 100th stock simply can't reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation.
"Anyone owning such numbers of securities after presumably studying their investment merit (and I don't care how prestigious their labels) is following what I call the Noah School of Investing – two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles. (I only made it through plane geometry, but with one exception, I have carefully screened out the mathematicians from our partnership.)"
Buffett has a great desire to outperform based on the way he was paid. Therefore, he was looking for investments where he could obtain at least 10% above what the Dow Jones Index would offer for a given year. Then, he analyzed what he could obtain and the probability of that upside turning into a reality. Buffett was clear in his remarks, saying that any investor who, in his attempts to diversify or enhance return, simply added securities for the sake of it was being overly simplistic (not to say naïve).
One of the best ways to achieve this is to apply the Kelly criterion, or to only invest in securities in which a good outcome is certain and we are knowledgeable of the company. With this approach, the amount of securities that check these two boxes will be naturally narrow, provided that after this, we need to verify that the valuation provides a sufficient margin of safety. Therefore, only a very limited amount of securities will be added to the portfolio.
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