What are Warren Buffett’s views on diversification? How would he structure his portfolio?
In 1962, Warren Buffett was already becoming famous for crushing the stock market yet doing so with far less risk than the normal portfolio. In his 1962 partnership letter, he gave his clients an overview of his investing strategy he calls ‘The Generals.”
In this blog I’m going to quote his letter in italics and then flesh out the point he’s making:
Warren Buffett’s Investment Strategy: The “Generals”
“We usually have fairly large portions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.”
In practice, this means that five or six stocks comprise about 50% of his portfolio with another 30% of the portfolio in ten to fifteen stocks. Mr. Buffett was investing about 80% of his portfolio of millions of dollars (in those early days) in about twenty total stocks that he bought for two reasons:
- They were available to buy really, really cheap
- They diversified his portfolio for safety
Here’s what he says about the stocks he’s buying:
“It is difficult at the time of purchase to know any compelling reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction.”
He is stating that he specifically is looking for stocks that have no good reason to go up. They aren’t in a hot industry. They don’t have new, exciting technology. They aren’t accelerating their earnings. And because there isn’t anything exciting going on to give the analysts and brokers something to spin about, owners of the stock are selling more than buyers are buying and the price just keeps going down. When the relationship between price and value gets right, Mr. Buffett buys.
But, since there is still nothing exciting going on after he bought any more than before he bought, there is still nothing to stop the selling and, therefore, many times after he buys a stock the price keeps dropping and later after it goes up, it could still drop back down with the market:
“Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market [these stocks] may very well go down percentage-wise just as much as the Dow….”
Warren Buffett Diversification
The second reason is diversification for lower risk:
“Combining this individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.”
What Buffett is calling “diversification” is a portfolio with 50% in 5 stocks and another 30% in about 15 stocks. By today’s standards, this portfolio would be considered intensely focused and not at all diversified.
Mr. Buffett has changed nothing in the intervening years, however…
He calls what your fund manager is doing buying 100 stocks a vast “over-diversification” that is sure to result in mediocre returns, returns that are less than the market itself because of your fund manager’s fees.
Mr. Buffett believes emphatically that the only way to consistently outperform the broad market is to focus one’s money on a few really good companies that are on sale.
This is investing.
Everything else is just speculating that the market will go up and is really just a game where you, the amateur investor, are the sucker at the table.
Warren Buffett’s Stock Portfolio
The way Buffett’s strategy works today is the same as 50 years ago and perhaps even a bit more concentrated. He has about 75% of his portfolio in 6 companies KHC, WFC, KO, IBM, AXP, PSX).
- Kraft Heinz Co. (KHC)
- Wells Fargo & Co. (WFC)
- Coca-Cola Co (KO)
- International Business Machines Corp. (IBM)
- American Express (EXP)
- Phillips 66 (PSX)
If you were to copy his basic structure, you’d buy 5 great, long-term stocks and get about half your money into them and after that, you’d add additional stocks to the portfolio by buying much smaller positions and then adding to those positions if the price dropped. (I call this “Stockpiling”.)
Once in a while, you’ll get a great opportunity to pour in a big pile of investment capital in something that is really great and really cheap.
When that happens you load up the truck.
Remember, Warren Buffett started with $100 and turned it into $30 billion. That means that it isn’t about the money you have, it’s about the knowledge you have. It means there are no real barriers to you getting rich if you’re willing to work hard and learn. When it comes to over-diversification, there are other stock market myths out there that are keeping you from riches. Learn what they are.