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Hello everyone. In this video, we'll hear Buffett describe why he recommends that serious, knowledgeable investors ignore conventional wisdom and purposefully maintain a concentrated stock portfolio. Make sure you stay until the end because you will learn how to apply these concepts that Warren Buffett explains to your own investment portfolio.
But first, make sure you like this video and subscribe to the channel, because my goal is to make you better investors by studying the best investors in the world. Without further ado, let's begin. The question is about diversification. And I have a twofold answer for that. If you are not a professional investor, if your goal is not to manage money in such a way that you obtain a significantly better return than the rest of the world.
So I believe in extreme diversification. In other words, I believe that 98% or 99%, maybe more than 99% of people who invest, should diversify extensively and not trade constantly. This leads them to a decision to invest in an index fund with a very low cost. Because all they're going to do is own a part of America, and they've decided that owning a part of America is worth it.
I don't disagree with that at all. That's how they should approach it, unless they want to add intensity to the game so that it's their own decision and start evaluating companies. But once you're in the business of evaluating businesses and decide that you're going to dedicate the effort, intensity, and time necessary to achieve it, then I think diversification is a terrible mistake, to any degree.
I was asked that question when I was at SunTrust the other day, and if you really know your business, you probably shouldn't own more than six of them. In other words, if you can identify six wonderful businesses, that's all the diversification you need, and you're going to make a lot of money; I guarantee you that investing in a seventh place instead of putting more money into the first has to be a terrible mistake .
Very few people have become rich with their seventh best idea. However, many people became rich with their best idea. Yes. Our mission is much bigger than our mission statement. Great opportunities in life should be seized. We don't do many things, but when we have the opportunity to do something that is right and great, we have to do it.
And even doing it on a small scale is almost as big a mistake as not doing it at all. In other words, you really have to take advantage of them when they come along. Because you're not going to get 500 great opportunities. You'd be better off if, upon leaving school here, you received a punch card with 20 spaces.
And every major financial decision you made would take up space. You would become very rich because you would think carefully about each one. I mean, you go to a party and someone talks about a company you don't even understand what it does or can't pronounce its name, but they made some money last week and then another one just like that .
You wouldn't buy it if you only had 20 slots on that card. There is a temptation to experiment, especially during bull markets. And the actions are so easy, you know. It's easier now than ever because you can do it online. You know, you just click and maybe it goes up a point, you get excited about that and buy another one the next day and so on.
You can't make money in the long run by doing that. But if you had a credit card with only 20 slots and you weren't going to receive another one for the rest of your life, you would think long and hard before every investment decision, and you would make good, big investments. And you probably wouldn't even use all 20 slots in your entire life, but you wouldn't need to.
You don't even have to follow the stock market to know that Warren Buffett is undoubtedly the greatest investor of all time. That said , you would think that he has made hundreds or thousands of successful investments throughout his illustrious career. But you might be surprised to learn that Buffett attributes his remarkable investment success to only a limited number of investments .
Although Buffett's company, Berkshire Hathaway, now owns hundreds of companies and stocks, it wasn't always like that . When Buffett was younger, he had an extremely concentrated stock portfolio. When he was 21, he liked GEICO stock so much that he put half of his entire net worth into this single stock.
Conventional wisdom says that an investor should diversify their investment portfolio across many stocks from different sectors of the economy. Investment textbooks and university finance professors say that risk is reduced by spreading money across a significant number of stocks. Why does Buffett differ in his approach?
After studying Warren Buffett, which includes reading all the essays he has written since 1965 and watching every interview he has given, there are four main reasons I can point out as to why the strategy of maintaining a concentrated portfolio has worked for Buffett. The first reason I point out is that Buffett truly sees stocks as ownership stakes in businesses and not just as pieces of paper whose price fluctuates.
Since Buffett truly understands the underlying fundamentals of the business, he is not concerned about short-term price fluctuations. That brings me to my second point. Buffett views risk differently than most investors. Conventional investment wisdom views risk as volatility, or simply put, how much a stock's price goes up or down .
Buffett is different. Instead, he defines risk as the probability of a permanent loss of investment capital due to a deterioration in the underlying performance of the business, not because of short-term movements in the company's stock price. The third reason is that Buffett invests in companies when there is a high margin of safety.
This means that it only invests in a company when the price it pays for a share is significantly lower than the actual value of the business. Or to put it another way, Warren Buffett only buys a stock when he gets it at a discount relative to the company's real value. This helps ensure that the probability of your investment being successful is high, meaning you feel more comfortable making a big bet because the chance of it working out is high.
The ultimate reason is that Warren Buffett tends to steer clear of technology stocks that are susceptible to rapid changes due to technology. Because technology companies can easily see their business destroyed by an unexpected technological change in society or by a competitor entering the market with superior technology, the lifespan of a technology company is significantly shorter than that of non- technology businesses, such as a railroad.
This makes large, concentrated investments in technology companies very risky due to a higher probability of permanent capital loss. This is why venture capitalists, who focus primarily on technology companies, distribute their investments across a wide range of companies. They know that most of their investments will probably fail, but the ones that work will more than compensate for all the ones that do n't.
Now that we understand the logic behind why Buffett recommends a concentrated portfolio, here is one of the best analogies I've heard from Warren Buffett about portfolio diversification. Although many professional and academic investors would say that an investor needs many stocks in their portfolio to be diversified, Buffett strongly disagrees.
He uses the hypothetical example of a local businessman. Imagine a businessman in his hometown. Let's assume this businessman owns the local McDonald's franchise, the most successful car dealership in town, some rental properties, and a factory that manufactures a product. Although this businessman only owns four businesses, wouldn't you say his wealth is quite diversified?
Of course . So, how is it different from stocks? Since stocks are only a partial ownership of a business, Warren Buffett argues that you should focus on your best ideas rather than buying stocks you do n't like as much just to have a diversified portfolio. There is another important question that needs to be answered.
Since Buffett is a big fan of portfolio concentration, does that mean everyone should be that concentrated? The simple answer is no. Researching investments is very time-consuming. Investors have to sift through hundreds or even thousands of companies to find just a handful that they can understand, that have solid business fundamentals, and that are selling at a reasonable price.
Buffett recommended that people who don't want to put in the effort to learn about investing and spend time researching stocks should do the opposite of what he mentioned in this clip. Buffett recommends that these people diversify widely. Specifically, it recommends investing in an S&P 500 index fund.
The S&P 500 is a stock market index composed of the 500 largest companies listed on U.S. stock exchanges . It is one of the most closely watched capital indices. This means that an investor who puts their money into this index has that money spread among the 500 largest publicly traded companies in the United States .
This helps ensure that investors are not overexposed to any particular stock, but rather own a share of American businesses. Although this strategy guarantees 100% that you will not outperform the market, it also ensures that you will not underperform the market. Many investors are perfectly content with receiving the average return of the S&P 500.
There's one more question you should ask yourself. Why does Warren Buffett preach portfolio concentration while owning hundreds of different businesses and stocks through his holding company, Berkshire Hathaway? The reason for this is the size of Berkshire Hathaway's investment portfolio . When you include cash, Buffett's managed portfolio approaches $400 billion.
This means that Buffett is managing a portfolio the size of the entire annual GDP of countries like Denmark, Ireland, and Colombia. There simply aren't enough large enough companies for Buffett to manage a concentrated portfolio the way he prefers. As a result, the portfolio he manages has become much more diversified than in the past.
Buffett attributes the size of the portfolio to its diminishing returns. So, there you have it . Be sure to like this video and subscribe to the channel if you found it helpful. We'll talk soon.
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