Warren Buffett: How Much Diversification You Need

Warren Buffett: How Much Diversification You Need

How much diversification in stocks is enough? The best investor of all time Warren Buffett answers this question for us.

You may be wondering, “how many stocks should I diversify in,” as you contemplate your portfolio’s asset allocation or how many eggs to have in your basket.

Warren Buffett gave his investment advice during a speech at the University of Florida in 1998.

If you’re not trying to get a significantly better return in the stock market, then Buffett believes in extreme diversification for 99% of people.

He said this leads most people to an index fund with a very low cost, and that most people should not be trading stocks. All you will do is own a part of America and you’re betting on its bright future in owning an index fund of, say, the S&P 500.

Buffett (or someone at Berkshire) is putting their money where their mouth is by having $30 million invested in the exchange traded funds: SPY and VOO, both S&P 500 index-based ETFs.

Now if you want to bring an “intensity to the game” and “start evaluating businesses,” then Buffett believes that “diversification is a terrible mistake.”

“If you really know businesses, you probably shouldn’t own more than six of them,” Buffett said.

Six wonderful businesses is all the diversification you need, and Buffett guaranteed going into your seventh business or stock rather than putting money into your first one “has gotta be a terrible mistake.” This is because very few people have gotten rich off of their seventh best idea and more likely have become rich on their best idea.

I point out the top equity holdings Buffett oversaw in Berkshire Hathaway’s 1998 annual report, listed in alphabetical order. Ironically Wells Fargo is number seven on this list, and eventually this investment became a mistake for Buffett that Berkshire sold out of Wells Fargo entirely by early 2022.

If you’re going to take the extra effort, time, and intensity to study businesses, Buffett gives simple investing instructions.

Buffett said that he liked businesses he can understand, and this narrows the pool of available businesses he can invest in by about 90%. This is known as investing within your circle of competence, or only what you are capable of understanding.

You want a business moat, and honest, hardworking, and able business management. Some of the businesses Buffett mentioned that meet his criteria include Coca Cola and car insurance company GEICO.

Buffett explained how the moat of Kodak fell apart as this photography business failed to adapt to changing business conditions.

You’re not buying a ticker symbol, you’re buying a piece of a business and that’s how we can think about investing in stocks.

Buffett said people can understand Coca Cola, but he doubted people could understand new Internet companies at the time.

And when someone asked if the market capitalization size matters, Buffett said it doesn’t matter if the company is large cap, mid cap, small cap, micro cap.

What matters is “can we understand the business, do we like the people running it, and does it sell for a price that is attractive?”

Buffett did admit that large cap stocks have done better than people expected, and you have American businesses earning close to 20% on equity, which is really impressive.

If American business is like a disguised bond that earns a 20% coupon, it’s better than a regular bond that only earns 13%. This has happened with big companies in recent years, but he’s skeptical if it will continue.

Buffett said See’s Candies was only a $25 million (so pretty small), but even with Berkshire’s size today he’d still love to buy another one. “It’s the certainty of it that counts.”

If you’re interested in learning how to take control of your finances and start becoming an investor like Warren Buffett, check out my free PDF guide.

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