Diversification
The practice of spreading investments across many securities to reduce risk, which Buffett argues is only necessary when you don't know what you're doing.
Concept Analysis
Definition & Origins
Diversification is the practice of spreading investments across many securities to reduce the impact of any single position's failure. Modern portfolio theory holds that diversification is the only "free lunch" in investing — it reduces volatility without necessarily reducing expected returns. Buffett's position rejects the dogma in both directions: broad diversification is rational, even optimal, for investors who cannot evaluate individual businesses, but it actively dilutes the results of investors who genuinely can.
Buffett staked out this position long before he had Berkshire's capital base to defend it. The material sent to partners in November 1965 announced a new Ground Rule — "we diversify substantially less than most investment operations" — permitting up to 40% of net worth in a single security under conditions coupling an extremely high probability of being right with a very low probability of drastic change in the underlying value. In the same letter he coined a label for the hundred-stock portfolio: the Noah School of Investing, two of everything, its adherents fit to pilot arks. The full framework — expected return falls as positions multiply beyond your best ideas, while the protection bought by each additional position shrinks toward zero — was in place decades before "di-worsification" entered popular vocabulary.
Core Ideas
Diversification protects against ignorance. The 1993 letter draws the line precisely. An investor who does not understand the economics of specific businesses should own a large number of equities and space out his purchases — the "know-nothing investor" who acknowledges his limitations, buys an index fund periodically, and thereby outperforms most professionals. For that investor, diversification is not a compromise; it is the correct strategy, and Buffett says so without irony.
Concentration can reduce risk rather than raise it. For the "know-something investor" — able to understand business economics and to find five to ten sensibly priced companies with durable competitive advantages — conventional diversification makes no sense. Buffett defines risk, in dictionary terms, as the possibility of loss or injury, not as price volatility. A concentrated portfolio forces exactly the intensity of thought about a business, and the comfort-level with its economics, that lowers the chance of permanent loss. Money added to a twentieth-favorite idea raises risk; it does not reduce it.
Over-diversification dilutes the returns from excellence. If analysis correctly identifies five businesses with exceptional long-term prospects, allocating capital equally across fifty positions dilutes those five excellent ideas with forty-five weaker ones. The mathematics are inexorable: the best ideas carry the highest expectations, and every inferior addition pulls the portfolio's overall expectation toward mediocrity — the one hundredth stock cannot reduce variance enough to compensate for what its inclusion costs.
Berkshire's apparent vs. actual diversification. Berkshire owns dozens of publicly traded stocks plus sixty-plus wholly owned businesses, and so appears very diversified. But a handful of positions — Coca-Cola and American Express in the 1990s, Apple and Bank of America later — has consistently accounted for the bulk of the equity portfolio, and the breadth that exists sits in businesses where genuine conviction exists, not in generic sector coverage.
Practical Application
The partnership era supplied the proof. The 1965 letter reports that the year's performance was overwhelmingly the product of five investment situations, with gains from those situations ranging from about $800,000 to about $3.5 million — while the five smallest general investments produced results Buffett called, choosing what he termed a very charitable adjective, lackluster. Looking back over nine years, he concluded he should, if anything, have concentrated slightly more, not less. Concentration in the best ideas was not incidental to the partnership record; it was the record.
The 1973–74 bear market repeated the pattern at larger scale. While institutions spread themselves broadly across a collapsing market, Buffett put new money into a small number of businesses he understood profoundly — the Washington Post purchase of 1973 being the 1993 letter's own example of an entire company offered at a vastly reduced price. Concentration in high-conviction ideas at moments of maximum fear, not diversification across low-conviction ones, produced the exceptional returns that followed.
The discipline also runs in reverse: position size must be matched to the balance sheet's capacity to survive being wrong. The 1984 letter explains that Berkshire's insurance companies concentrate their investments in a way that "makes sense only because our insurance business is conducted from a position of exceptional financial strength" — for almost all other insurers, anything close to that degree of concentration would be totally inappropriate, because their capital cannot withstand a big error.
Common Misconceptions
Misconception 1: Berkshire is highly diversified. Berkshire's equity portfolio concentration in a handful of positions makes it more concentrated, not less, than a typical institutional portfolio. The apparent diversification lies in the wholly owned businesses — and those businesses' combined fate remains substantially correlated with U.S. economic conditions, which is a single bet of its own kind.
Misconception 2: More holdings always reduce risk. Beyond a modest number of carefully selected positions, additional diversification reduces volatility only marginally while steadily diluting returns for any investor with a genuine analytical edge. The 1965 letter's arithmetic still stands: the one hundredth stock cannot reduce potential variance enough to compensate for the negative effect its inclusion has on overall portfolio expectation.
Misconception 3: Concentration and diversification are simple opposites — one risky, one safe. The 1993 letter rejects the premise twice over. First, it attacks the academic definition of risk as volatility: under beta theory a stock that has fallen sharply becomes "riskier" at the lower price, which is absurd to anyone offered the whole business at that price. Second, it concedes entire categories where wide diversification is exactly right — arbitrage, and venture capital generally — where each transaction carries real risk of loss and the payoff comes from probabilities playing out across many mutually independent commitments, the casino refusing the single huge bet. The correct variable is never the raw count of positions; it is the match between position size, the investor's understanding, and the probability-weighted payoff.
Buffett's Own Words
There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can't reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation.
Anyone owning such numbers of securities after presumably studying their investment merit (and I don't care how prestigious their labels) is following what I call the Noah School of Investing - two of everything. Such investors should be piloting arks.
With our financial strength we can own large blocks of a few securities that we have thought hard about and bought at attractive prices. (Billy Rose described the problem of over-diversification: “If you have a harem of forty women, you never get to know any of them very well.”) Over time our policy of concentration should produce superior results, though these will be tempered by our large size. When this policy produces a really bad year, as it must, at least you will know that our money was committed on the same basis as yours.
Further diversification for Berkshire followed, and gradually the textile operation’s depressing effect on our overall return diminished as the business became a progressively smaller portion of the corporation.
The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."
Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: "Too much of a good thing can be wonderful."
When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor's take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.
Thought Evolution
Related Concepts
Case Companies
The scandal-driven purchase that became the partnership's emblematic concentrated bet, made under the policy later capped at 40% of net worth in a single security
An entire strong company bought at a vastly reduced price during maximum market fear; the 1993 letter's own case against volatility-as-risk
A cost-advantage franchise accumulated across decades, from the 1951 stock purchase to the 1976 rescue to the 1996 buyout of the remaining half
The largest single equity position Berkshire has ever held: late-era concentration at unprecedented scale