Warren Buffett has often said that the average investor should practice diversification by investing in index funds.
I’ve written several times (here, here, and here) about index funds and how investing in an S&P 500 index fund and using a dollar-cost averaging strategy is a great way to make money in the stock market over the long-run – and this point has been well documented by both research and results.
Part of the magic in this strategy is that an investor who doesn’t have much experience and who doesn’t know how to analyze or calculate the intrinsic value of a stock… doesn’t have to.
Instead, he or she can invest in all of the stocks in the stock market – thereby diversifying risk while earning the average return of the entire stock market (which has historically been ~9.5% over the long-run). And Warren evidently agrees with this.
However, Warren Buffett sings a very different song for investors who want to beat the average stock market return.
Warren Buffett on Diversification
Warren does not believe an investor who wants to generate an above-market return should diversify his or her holdings. Here are some of his quotes on this subject:
Warren’s saying that if you invest in too many stocks in pursuit of portfolio diversification, you (a) take yourself out of your circle of competence and (b) lose the intensity and concentration that you would have if you were only thinking about a few great businesses.
Warren Buffett on Seizing Big Opportunities
Warren Buffett described the below analogy during a lecture he gave to University of Georgia business school students in 2001. This “20 slot punch card” approach to investing underscores just how focused Buffett is when it comes to investing and highlights how we should all seize and capitalize on big opportunities when they come our way.
Diversify or Not?
So what is Warren really saying? Should you diversify or not? Absolutely! Just not too much.
What Warren does (and has done for decades) is build focused portfolios of businesses and holds them. Warren will continue to hold the business until the fundamentals change unfavorably, or he finds better opportunities. That’s it. One thing Warren does not do is sell his top performing positions and allocate those funds elsewhere. Why is this?
Just like Tom Brady
Tom Brady is the absolute best example of value investing. Bear with me…
Back in 2000, the New England Patriots drafted a no-name QB from Michigan in the sixth round of the draft to fill their bench. Most probably thought of Brady as just that, a bench warmer. When Brady got his first real chance to play in 2001, he crushed it. He then went on to lead the Patriots to the Super Bowl that season.
So, after winning that first season, why didn’t the Patriots trade their most valuable player? He was clearly worth a lot more now. They could get a good trade for him. Instead, they went on to re-sign him for contract after contract. Brady responded by winning the franchise five more Super Bowl championships.
Rather than monologue about how awesome Tom Brady is, I think you get the picture. The Patriots made a cheap value stock pick (sixth round draft pick) and held him. They recognized his potential and held onto their most prized asset; and they were greatly rewarded!
You should think of your investment portfolio the same way. Unless the fundamentals of the business changes significantly, stay the course. Let the business (or athlete) compound for you while you reap its rewards.