The Case Against Diversification: A Concentrated Wisdom from Buffett and Munger (Investing Advice)
Embracing the Wisdom of Omaha: Why Buffett and Munger Advocate for Concentrated Investing Over Diversification
The arena of investing is extremely counterintuitive. The advice oft-given for most investors is typically the opposite of what one who invests full-time should do. Diversification is and will remain protection from ignorance - am I (and by extension you) ignorant? I certainly hope not! I mean, after all, you’re reading this article about investing in your free time :)
Buffett and Munger share their thoughts in this great clip on this topic here:
In the theme of contrarian thought and investing Warren Buffett and Charlie Munger, the legendary duo behind Berkshire Hathaway, have long championed a radically different approach: concentration over diversification. In this article, we channel their perspective, distilling decades of wisdom into a cogent argument for why one should focus on their top ideas.
The Illusion of Safety in Numbers
Diversification, as commonly practiced, is predicated on the assumption that spreading investments across a wide array of assets will mitigate risk. However, Buffett and Munger argue that this approach often dilutes not just potential risk, but potential reward as well. The safety promised by diversification is largely illusory, especially if it leads investors to commit capital to businesses they understand poorly or to mediocre enterprises with bleak prospects.
Diversification is protection from price volatility not risk!
Traditional modern portfolio theory unfortunately equates volatility with business risk. The fancy formulas showing that the variance of a portfolio can be reduced by replacing it with the covariances of two positions (covariance being less than the variance) lends academicians to suggest the whole market portfolio as the optimal investment.
My first class in Econ I had a TA suggest to me that taking things to an extreme can help elucidate the nature of whether an assertion is correct or not, so let’s take this assertion to the natural consequence. Let’s see I have a business that has a negative enterprise value and a profitable history over its past 100 years (yes this is a real company that I may write about someday, if you’re a founding member I can let you know the Ticker). Would it make sense to diversify away from this and invest into Wirecard AG (a company that went bankrupt after it was found to be comitting accounting fraud)? Absolutely not. Business risk is still a metric that cannot be measured and therefore cannot be reduced via covariances. Therefore practitioners of the art of intelligent investing can still make supernormal returns.
The Power of Concentrated Knowledge
The cornerstone of Buffett and Munger's investment philosophy is deep, rigorous analysis followed by concentrated investment in high-quality businesses. They advocate for investing in what you know intimately, a principle Munger often encapsulates with the term "circle of competence." The logic is straightforward: when you focus your efforts on understanding a few select businesses deeply, you significantly increase your chances of success. This depth of knowledge enables an investor to identify significant competitive advantages, or "moats," that ensure long-term profitability and protection against competitors.
Quality Over Quantity
Buffett and Munger's disdain for diversification is matched by their appreciation for quality. They argue that it's far better to own a small number of outstanding businesses than a large portfolio of mediocre ones. An outstanding business, in their view, is one that can generate superior returns on capital over a long period, has a durable competitive advantage, and is run by capable and honest management. The idea is to invest in companies that one believes could be held forever.
The Psychological Aspect
Concentration requires not just a deep understanding of the business, but also a temperament that can withstand the market's vicissitudes. Buffett and Munger stress the importance of emotional discipline and patience, qualities that are tested when an investor's holdings are few and potentially volatile. The ability to keep a cool head when the market is in turmoil is crucial. Concentrated investing is not for the faint-hearted, nor is it suitable for those who equate portfolio activity with success.
The Proof Is in the Performance
The proof of the efficacy of concentrated investing, as advocated by Buffett and Munger, is in the remarkable track record of Berkshire Hathaway. Over the decades, through focused investments in companies like Coca-Cola, American Express, and Apple, they have demonstrated the tremendous potential of a well-curated, concentrated portfolio. These investments were made not out of a desire to diversify, but from a conviction in the exceptional quality and long-term prospects of these businesses.
Conclusion
While the conventional wisdom on diversification has its merits, especially for the average investor without the time or inclination to thoroughly research their investments, Buffett and Munger present a compelling case for a different path. Concentrated investing, rooted in a deep understanding of a few outstanding businesses, offers the potential for superior returns. It demands a combination of knowledge, discipline, and patience but, as the legendary investors from Omaha have shown, the rewards can be extraordinary.
In the end, the debate between diversification and concentration may not be a question of right or wrong but of suitability. For Buffett and Munger, concentration is not just a strategy but a philosophy, one that has served them and their shareholders exceptionally well over the years. If it’s worked for them, then it will most certainly work for you.