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Why Warren Buffett may be the most dangerous man in finance

Thursday, Jan 12 2012 by
5
The Quotable One
The Quotable One

Warren Buffett is a smart guy and has ascended to a near immortal pantheon amongst the investment community due to his superior stock picking skills and boundless wealth. But listening to his views on portfolio management and diversification could cripple your financial health and may make him one of the most dangerous men in finance.

One of the reasons for Warren’s fame is his gift for writing simple prose and quotable aphorisms. These snippets of wisdom from the guru have been repeated so many times they are like mantras for amateur and professional investors. But given that our soundbite culture has a tendency to completely remove quotations from their original context and treat them as truths in their own right Warren perhaps should be a little more careful in his choice of words.

Lets have a look at a few…

“Diversification is a protection against ignorance.”

Warren Buffett and Charlie Munger became billionaires by betting the farm in size, then betting it again and again. They are the epitomy of investment expertise - educated and mentored by the best minds in the business. For investors of such gifts, a focused portfolio can make sense - indeed other famed investors like Bill O'Neil and Joel Greenblatt might even agree - but given that 99% of Buffett’s readership are armchair investors in professions other than finance a quote like is just plain dangerous serving to justify massively oversized betting in speculative stocks. The empirical evidence has proven that individual investors in general suffer from an array of financially crippling behavioural biases including over-confidence, loss aversion and herding - which can be summarised as forms of ‘general ignorance’. These biases lead to over-trading, under-diversification and poor market timing and have been shown to cost individual investors $160bn annually. Buffett should perhaps have rephrased that quote “You are most likely completely ignorant, so you’d best protect yourself and get diversified”.

“I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches ‐ representing all the investments that you got to make in a lifetime.”

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Is Buffett even sure that most investors get to their 20th investment? While it is true that there is huge over-diversification amongst institutional investors who may have up to 200 stocks in their portfolios, its just not true of private investors. In a study of 60,000 investor portfolios at one of the US’s biggest discount brokerages during the early 1990s it was shown that the average portfolio contained only 4 stocks. Not only that, but the average portfolio’s holdings were highly correlated meaning that their apparent 4 way diversification was a mirage. If such investors had better stock picking skill then you’d imagine they would outperform the market, but the study showed that as a group, the least diversified portfolios underperformed the most diversified portfolios by 2.4% per year. At that rate most of these portfolios might go bust before they even got to their 20th investment! Again the evidence shows that Buffett’s audience just aren’t that smart.  A current analogy might be the levels of correlation amongst the stocks in UK SIPPs and ISAs which are significantly overweight the oil sector especially in such names such as Gulf Keystone Petroleum (LON:GKP) and £RR. .

“Wide diversification is only required when investors do not understand what they are doing.”

And there he goes again - completely misunderstanding the fact that because everybody thinks they know what they are doing they’ll take this advice the wrong way and underdiversify!  Surely you’d think Charlie Munger should have ticked him off by now?

The danger is that the longer Warren Buffett is given the lectern, the more his cute anti-diversification aphorisms are going to filter down to the everyman investor to help justify their ill-educated limbic brain stems hitting the trade button in oversized quantities. The net financial effect of individual investor’s general ignorance, under-diversification and risk taking is a $160bn annual wealth transfer from their wallets to smarter institutional investors. One can imagine that a fair chunk of that has found its way to Berkshire Hathaway’s pockets over the last 30 years the irony of which ought to lead to a wry chuckle from the Quotable One. Given that Warren has an audience that shows such a terrible level of investment skill and that he is so well positioned to take advantage their errors should he even be given the mike?

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7 Comments on this Article show/hide all

MrContrarian 12th Jan '12 1 of 7
3

And there he goes again - completely misunderstanding the fact that because everybody thinks they know what they are doing they’ll take this advice the wrong way and underdiversify!  Surely you’d think Charlie Munger should have ticked him off by now?

That's a great insight. Buffett and Munger are several sigma above the average at identifying enduring competetive advantage.

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emptyend 12th Jan '12 2 of 7
3

The net financial effect of individual investor’s general ignorance, under-diversification and risk taking is a $160bn annual wealth transfer from their wallets to smarter institutional investors.

I don't think that is a fair deduction from the $160bn study that you quote from. As you say in the other thread:

a clue can be gained from the sources of the losses:"These losses can be broken down into four categories: trading losses (27%), commissions (32%), transaction taxes (34%), and market-timing losses (7%)

...there is nothing there about under-diversification or even ignorance or risk-taking. Nearly three-quarters of the $160bn is simply down to frenetically trading in and out of the market - which is something that is the antithesis of Buffet's approach!

It seems to me that the key to successful investment is to know when you "know nothing special"....and to structure your portfolio accordingly. This applies to well over 90% of people, for well over 90% of their lives!.......

....but once in a while, people may (if they are very lucky!) stumble a "once in a lifetime" opportunity. And then the key is to recognise it and organise one's portfolio to take maximum advantage of it (to the extent that this can remain consistent with one's life needs!). Obviously Buffet, being far far wealthier than he actually needs to be, has total flexibility to back his beliefs without damaging his very modest lifestyle.....and that is a state to which very very few of the rest of us can reasonably aspire to - which is why some level of diversification is important, even for those who have very strong views.

ee

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UK Value Investor 12th Jan '12 3 of 7
3

To be fair he does also say that most people are better off with an index tracker and he does love to talk so he's bound to mention (repeatedly) his own stock and company picking approach even if it isn't appropriate for the vast majority of people.

It's just that he's so soundbiteable the media love it and spin these one-liners out which in turn create the simplified version most people know, which of course includes being highly concentrated.

I think the main thing he fails to mention is the work involved in his approach. He often says that you don't need more than 130 IQ points or whatever, which may be true, but his approach to investing involves consuming and digesting vast amounts of information about a company, its industry and the nature of business in general. That information then has to be processed through a mental web that includes very novel insights into how companies work, how accounting works and many other things that mere mortals are never going to understand - 130 IQ points or not.

You only have to read their biographies to see that Buffett and Munger are very un-typical people to say the least and so copying them might work out about as well as me trying to copy the gymnastic routine of the latest 16 year old female olympic sensation.

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thebuffoon 12th Jan '12 4 of 7
1

An investor with only four stocks in their portfolio will still be extremely likely to have far more than 20 investments in his lifetime.

The fact that people may think they are not ignorant, and therefore (in your eyes) under diversify, does not make his statement that “Diversification is a protection against ignorance.” untrue.

I can't find fault with any of his aphorisms. Then again, I don't have a background in the City with an article to write.

Buffy

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Daytona 15th Jan '12 5 of 7
2

Ignorance is part of the human condition, the rich tapestry of life, if you will. There is very little that can be done about it - it is Darwinianism at work.

Buffett is a private individual entitled to freedom of speech. He says it how he sees it. He carries no responsibility for gamblers ignorance.

but given that 99% of Buffett’s readership are armchair investors in professions other than finance a quote like is just plain dangerous serving to justify massively oversized betting in speculative stocks.

If it does, then it's the fault of those armchair 'investors'. What would you prefer - that all the experienced knowledgeable investors out there are reduced to talking in neutered, politically correct, child speak ?

A current analogy might be the levels of correlation amongst the stocks in UK SIPPs and ISAs which are significantly overweight the oil sector especially in such names such as Gulf Keystone Petroleum (LON:GKP) and £RR. .

That's interesting - I should be horrified but I'm not, it's just karma - where did you get this information - can you expand and perhaps write some occasional articles when significant correlated imbalances such as this occur ?

It doesn't surprise me, because I've seen more gamblers come into the market, attracted by the volatility induced by the credit crisis, during the last few years than at any other time during 25 years of investing. WShak on TMF used to write insightful posts about his occasional chats with his broker about the state of their private investor clients trading on margin, I'd be interested to know if their experience matches my own perception of recent events.

No doubt many of them have been wiped out during the volatility of the last 6 months, and that's how it should be - a wealth transfer from the stupid to the intelligent; from the ignorant to the informed; from the gullible to the discerning. Another variant of the Stupid Tax. After all, sensible investors need someone on the other side of their trade.

 

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Steven Dotsch 20th Jan '12 Reported for Advertising
4

Us mortals can only aspire a track record as that of Warren Buffett's!

Book: Guide to Dividend Investing
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DAltman 5th Feb '13 7 of 7

"Is Buffett even sure that most investors get to their 20th investment? ...its just not true of private investors".

Basing your assertion (and hence much of your article's conclusion) on a study from the early 1990s is quite ludicrous IMO. If you want your claims to be taken seriously, at least use a study that may have some correlation with the present, when the world and his wife have internet broking accounts and trade online... 

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About Edward Croft

Edward Croft

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CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »


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