It might surprise you to learn that Warren Buffett advocates a completely different investing style than the one he practices. While Buffett has 51% of his equity portfolio allocated to Apple shares, he encourages most investors to diversify their holdings much more broadly.
The advice seems so paradoxical to his day-to-day investing approach that it naturally leads to further investigation to understand his stance.
Why does he concentrate his holdings at Berkshire Hathaway but recommend others spread their capital across a wide-range of stocks?
What Does Warren Buffett Say About Diversification?
Buffett has commented frequently about diversification. Some of his most famous quotes on the topic include:
The reason Buffett encourages others to diversify while not practicing what he preaches is that most investors don’t spend their days doing the due diligence needed to find great investments.
While Buffett famously will spend most of his waking hours reading, ordinary investors are consumed by other day-to-day activities, whether working a job, exercising, socializing with friends, or taking care of family, for example.
In order to get an edge and beat the market, Buffett believes an investor needs to own only a few great businesses but in order to find them they must sift through a lot of firms that don’t meet the necessary criteria to warrant investment.
In order to earn Buffett’s vote of confidence, a company must generally have a number of key attributes in its favor. A primary focus for Buffett is whether the company has a strong competitive advantage, otherwise known as a moat. If an economic moat exists, the odds of another firm stealing its market share is low. It also allows the company to sustain higher prices and margins.
Warren also likes businesses he owns to have consistent and predictable earnings power. These two criteria combined signal that, over the long-term, the business can withstand the swings of economic boom and bust cycles.
A further, but often overlooked by retail investors, factor that he pays close attention to is the quality of a management team. Specifically, he looks for leadership to be capable, competent, experienced, and have high integrity. Evidence of that can be seen in how well management allocates capital to grow the business and how they resolve ethical challenges.
Another key characteristic is the ease with which he can understand a business. You won’t generally find Buffett sniffing around artificial intelligence stocks, or disruptive technology stocks. He is not looking for the next big innovation but rather stays within what he calls his “circle of competence”, sticking within business models he thoroughly understands.
Perhaps a factor as important as having an economic moat for Buffett is the price he pays for an investment. When he began investing he claims that good businesses at great prices were his focus but over time, as competition in the investing space grew, he evolved to focus on great businesses at fair prices.
You will often see Buffett buy shares of stocks that have share buyback schemes in place. These often act as cushions supporting share prices, and they naturally increase his ownership stake in the businesses without him having to invest more money. So too do they end up reporting higher earnings per share because share counts drop.
How Does Buffett Encourage Investors To Diversify
In order to diversify risk, Buffett recommends that most investors own an ETF that tracks the S&P 500.
The genius behind this advice is often overlooked by investors, particularly those who believe they can beat the market.
For one, history has shown that most active investors do not in fact beat the market so the S&P 500 acts as a protection for most ordinary investors.
Buffett has famously stated that “paradoxically when dumb money realizes it’s dumb it becomes smart” meaning that by recognizing you don’t have an edge and are unlikely to beat the market, you can actually outperform most active investors by earning “average” market returns.
The S&P 500 also has a natural mechanism built-in to cull poor companies and add the best companies to its index. An actively managed portfolio, by contrast, requires constant supervision to weed out the weak companies and find the best ones. That in turn demands a lot of homework, which few have the time or willingness to do.
Buffett has suggests a low-fee S&P 500 ETF like that offered by Vanguard with ticker symbol VOO is perhaps the best way for most investors to gain exposure to the market.
Obviously, the downside of selecting this approach is that there is no way to actually beat the market. By definition, VOO tracks the S&P 500 but it will never eclipse it.
Equally, though, it is designed not to underperform the market. Essentially, an investor must accept that they will earn the same returns as the stock market, not over-performing or under-performing.
The bottom line is, for most investors, a diversified approach is a better bet according to Buffett than an actively managed one.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.