Warren Buffett - You should not diversify; It makes sense only in these two instances

Key takeaways at the end

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Of course, some investment strategies [...] require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. 

Thus, you may consciously purchase a risky investment [...] if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. 

Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his / her interest to be a long-term owner of American [or any other] industry. 

That investor should both own a large number of equities and space out his / her 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 / her 20th favorite rather than simply adding that money to his / her top choices – the businesses he / she 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."

1993 Shareholder Letter

* Bold emphasis added

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Key concepts and takeaways:

• When diversification makes sense: If you are playing the numbers / probability game, it definitely makes sense to hold a large number of mutually independent bets. Venture capitalist typically take this approach.  Also, it makes sense if you are a “know-nothing” investor, or you simply do not have time to do your own research. In that case it is better to get exposure to a cheap, well-diversified index and save your time for other activities.

• When diversification does not make sense: If you are a “know-something” investor and want to invest in public equities, you are better off concentrating your portfolio if a few great companies - note that Buffett suggests having only five to ten companies. Just purely statistically, the more companies you have in your portfolio, the closer you are to achieve market-like returns. What is then the point of all the time and effort spent. You can also have a combination few stocks and a well-diversified index. Read earlier post to understand in more detail why diversification might increase the risk of your portfolio.