“we think diversification is as practiced generally makes very little sense for anyone that knows what they’re doing. ” -Warren Buffett

Warren Buffet 1996 at Berkshires Annual Shareholder’s meeting

The year is 1996 at the Berkshire Hathaway annual meeting. A question has been sprung by a shareholder asking Warren Buffett and Charlie Munger about their approach to and thoughts on diversification. An age old saying “diversify, diversify, diversify” but what do the two moguls have to say about it? Here is a transcript of what transpired that afternoon.

Video Courtesy of The Financial Review

Investor Question

My name is Mark Hake I’m from Scottsdale Arizona and I am very interested in your policies on diversification and also how you concentrate your Investments and I’ve studied your annual reports going back a good number years and there’s been years where you had a lot of stocks in your marketable equitable securities portfolio and there was one year we only had three 1987.

So, I have two questions given the number of stocks that you have in the portfolio now, what does that imply about your view of the market in terms of is it fairly valued that kind of idea. Second of all whenever you it seems that whenever you take a new investment you never take less than about 5% and never more than about 10% of the total portfolio with that new position and I wanted to see if I’m correct about that. 

Warren Buffett

Yeah well on the second point, that there really is incorrect. We have positions that you don’t even see because we only listed the ones above 600 million in the last report and obviously those are all smaller opposition sometimes that’s because they’re smaller companies and we couldn’t get that much money in and sometimes it’s because the price has moved up after we bought it, we may be selling the position down even but so we have no but there’s nothing magic we like to put a lot of money and things that we feel strongly about going back to the diversification question, we think diversification is as practiced generally makes very little sense for anyone that knows what they’re doing.

Diversification is a protection against ignorance, I mean if you want to make sure that nothing bad happens to you relative to the market you own everything there’s nothing wrong with that I mean that there’s a perfectly sound approach for somebody who does not feel they know how to analyze businesses. If you know how to analyze businesses and value businesses it’s crazy down 50 stocks or 40 stocks or 30 stocks probably because there aren’t that many wonderful businesses that are understandable to a single human being in all likelihood and to have some super wonderful business and then put money and number 30 or 35 on your list of attractiveness than and forgo putting more money in the number one just strikes Charlie and Me as madness and it is conventional practice and it if all you have to achieve is average it may preserve your job but it’s a confession in our view that you don’t really understand the businesses that you own .

On a personal portfolio basis and I own one stock, but it’s a business I know and it leaves me very comfortable. So do I need to own 28 stocks to have proper diversification? It would be nonsense, within Berkshire I could pick out three of our businesses and I would be very happy if they were the only businesses we own and I had all my money in Berkshire now I love it the fact that we can buy more than that and we keep adding to it but three wonderful businesses is more than you need in this life to do very well and the average person isn’t going to run into that and if you look at the fortunes were built in this country they weren’t built out of a portfolio of 50 companies they were there were built by someone who identified with a with a wonderful business Coca-Cola is a great example, a lot of Fortune’s have been built on that.

There aren’t 50 Coca-Colas there aren’t 20 if there were it would be fine we, we could all go out and diversify like crazy among that group and get results that would be equal to owning a really wonderful one but you’re not going to find it and and the truth is you don’t need it.  A really wonderful business is very well protected against against the vicissitudes of the economy over time and the competition we’re talking about businesses that are resistant to effective competition and three of those will be better than a hundred average businesses and will be safer incidentally I mean they there is less risk and owning three easy to identify wonderful businesses than there is in owning 50 well-known big businesses and it’s amazing what has been taught over the years in finance classes about that but I can assure you that that I would rather pick if I had to bet the next 30 years on the fortunes of my Family that would be dependent upon the income from a given group of business I would rather Pick 3 stocks from those we own than a diversified group of 15, Charlie? 

Charlie Munger

What he is saying is that much of what is taught in modern corporate finance courses is twaddle, you cannot believe this stuff I mean it’s modern portfolio theory.

Warren Buffett

It has no utility I mean it will tell you how to do average but you know anybody can figure out average in 5th grade and it’s just not that difficult, it’s elaborate and there’s lots of little greek letter to make you feel like you’re in the big leagues but uh there is no value added.

Charlie Munger 

And I have great difficulty with it because I’m something of a student of dementia

Warren Buffett

Yeah we hang around a lot together

Charlie Munger

I get an ordinarily classified dementia on Theory structure of models but the modern portfolio Theory, it involves a type of dementia I can’t even classify, something very strange is going on.

Warren Buffett 

If you find three wonderful businesses in your life to get very rich and if you understand, bad things aren’t going to happen to those three I mean that that’s the characteristic of it.

Charlie Munger

By the way, maybe that’s the reason there is so much dementia, if you believe what Warren said, you could teach the whole course in about a week.

Warren Buffett

Yeah and the  high priest wouldn’t have any edge over the lay people and that never sells well.

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