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.”
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?