Warren Buffett - Why diversification might lead to higher risk

Key takeaways at the end

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Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions. [...] Therefore, we adopted a strategy that required our being smart – and not too smart at that – only a very few times. Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. 

We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."

Academics, however, like to define investment "risk" differently, averring that it is the relative volatility [/price fluctuation] of a stock or portfolio of stocks – that is, their volatility as compared to that of a large universe of stocks. 

Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock – its relative volatility in the past – and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

For owners of a business – and that's the way we think of shareholders – the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market [...] becomes "riskier" at the lower price than it was at the higher price. ...

... In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced "Mr. Market", an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. 

That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. 

In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two.

1993 Shareholder Letter

* Bold emphasis added

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Key concepts and takeaways:

• Diversification ≠ lower risk: Your time is limited. It is better to focus on making fewer and better educated decisions, than to try to diversify risk by managing a portfolio comprising a large number of assets. In my experience, investments also require a good level of monitoring. By that I do not mean monitoring daily share price movements, but staying on top of key megatrends, what the competition is doing, how the company is allocating capital and what are the returns on investments that the company is making. This also comes back to the concept of “circle of competence” discussed in a separate post.

• Mr.Market: Manic-depressive fellow that is sometimes willing to sell you an asset at an attractive price.