Thursday, October 21, 2010

Buffett on Diversification

The following is from a Buffett partnership letter that was written in early 1966:*

"We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations."

"...I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year--one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater."

"It is worth pointing out that our performance in 1965 was overwhelmingly the product of five investment situations."

"All texts counsel 'adequate' diversification, but the ones who quantify 'adequate' virtually never explain how they arrive at their conclusion. Hence, for our summation on overdiversification, we turn to that eminent academician Billy Rose, who says, 'You've got a harem of seventy girls; you don't get to know any of them very well.'"

Those who might have somewhat less -- or a whole lot less -- investment skill plainly need more diversification. This necessitates a realistic assessment of capabilities and limits.

The Buffett partnership letters can be found here.

* Written in early 1966 by Warren Buffett to discuss the previous year's performance.

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