1996: How does Buffett think about diversification and portfolio construction?

AUDIENCE MEMBER: Yeah, my name is Mark Hake (PH). 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 of years, and there’s been years where you had a lot of stocks in your marketable, equitable securities portfolio. And there was one year where you only had three, in 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?

And second of all, whenever you — it seems that, whenever you take a new investment, you never take less than about 5 percent and never more than about 10 percent 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 really isn’t correct.

We have positions which you don’t even see, because we only listed the ones above 600 million in the last report. And obviously, those are all smaller positions.

Sometimes, that’s because they’re smaller companies, and we couldn’t get that much money in. Sometimes, it’s because the prices moved up after we’d bought them. Sometimes, it’s because we may be selling the position down, even. So there’s nothing magic.

We like to put a lot of money in things that we feel strongly about. And that gets back to the diversification question.

You know, 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 — (laughter) — that nothing bad happens to you relative to the market, you own everything. There’s nothing wrong with that. I mean, that is 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 to own 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 in number 30 or 35 on your list of attractiveness and forego putting more money into number one, just strikes Charlie and me as madness.

And it’s conventional practice, and it may — you know, if you 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.

You know, I base — on a personal portfolio basis — you know, I own one stock. But it’s a business I know. And it leaves me very comfortable. (Laughter)

So you know, do I need to own 28 stocks, you know, to have proper diversification, you know? It’d be nonsense.

And within Berkshire, I could pick out three of our businesses. And I would be very happy if they were the only businesses we owned, and I had all my money in Berkshire.

Now, I love it — the fact that we can find more than that, and that 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. I mean, if you look at how the fortunes were built in this country, they weren’t built out of a portfolio of 50 companies. They were built by someone who identified with a wonderful business. Coca-Cola’s a great example. A lot of fortunes have been built on that.

And there aren’t 50 Coca-Colas. You know, there aren’t 20. If there were, it’d be fine. We could all go out and diversify like crazy among that group and get results that would be equal to owning the really wonderful one.

But you’re not going to find it. And the truth is, you don’t need it. I mean, if you had — a really wonderful business is very well protected against the vicissitudes of the economy over time and the competition.

I mean, you know, we’re talking about businesses that are resistant to effective competition. And three of those will be better than 100 average businesses.

And they’ll be safer, incidentally. I mean, there is less risk in 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 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 businesses, I would rather pick three businesses from those we own than own a diversified group of 50.

Charlie?

CHARLIE MUNGER: Yeah, what he’s saying is that much of what is taught in modern corporate finance courses is twaddle. (Laughter and applause)

WARREN BUFFETT: You want to elaborate on that, Charlie? (Laughter)

CHARLIE MUNGER: You cannot believe this stuff. I mean, it’s modern portfolio theory and — yeah, it’s —

WARREN BUFFETT: It has no utility. But you know, it will tell you how to do average. But, you know, I think anybody can figure out how to do average in fifth grade. I mean, it’s just not that difficult, and —

It’s elaborate. And you know, there’s lots of little Greek letters and all kinds of things to make you feel that you’re in the big leagues. But it — (laughter) — there is no value added. (Laughs)

CHARLIE MUNGER: I have great difficulty with it because I am something of a student of dementia — (laughter) — and I have —

WARREN BUFFETT: And we hang around a lot together. (Laughter)

CHARLIE MUNGER: And I get ordinarily — classified dementia, you know, on some theory, structure of models. But the modern portfolio theory, it involves a type of dementia I just can’t even classify. (Laughter)

Something very strange is going on. (Buffett laughs)

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

CHARLIE MUNGER: By the way, maybe that’s the reason there’s so much dementia. If you believed what Warren said, you could teach the whole course in about a week. (Laughter)

WARREN BUFFETT: Yeah, and the high priests wouldn’t have any edge over the laypeople. And that never sells well. (Laughter)

CHARLIE MUNGER: Right.