Wednesday, 28 October, 2009

Diversification - Warren Buffett's Thoughts on Diversification

Warren Buffett's Thoughts on Diversification
And why I disagree with him for a change!

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing" - Warren Buffett

Very interesting quote, indeed.

Specific Disclaimer: I'm not too sure whether this is an authentic quote nor am I aware of the context in which the quote was made.

However, for the limited purpose of this post, I'm assuming the authenticity of the quote and proceeding further.

Obviously, for a given time horizon, if we consider the universe of listed entities on the Bombay or National Stock Exchanges, a specific scrip, let's call it ABC Ltd., will produce the maximum returns and a specific scrip, let's call it XYZ Ltd.,  will destroy the maximum value for its investors. And all the other scrips will have performance levels somewhere within that range.

So, as rightly pointed out by Buffett, it ought to imply that all of us should sell all the rest of our portfolio of longs and go long on ABC Ltd., and, likewise, use our "Short" positions exclusively for XYZ Ltd.

I wish that life is so simple.

Unfortunately, it is not.

Here are a few reasons as to why I disagree with Warren Buffett (and why I prefer diversification any day):

  • Nobody can predict the future that precisely.
  • Any significant, material, price-sensitive event that has a positive / negative impact on either that stock or that sector or some other stock can swing the price of your stock wildly, thereby throwing your calculations out of the window. Examples abound:
    • A sudden Lehman Brothers can deplete the value of some other Financial Giant vis-a-vis a Pharma major, for instance.
    • An outbreak of Swine flu or a major Class Action Suit on an unanticipated side effect on a popular drug can impact the price of your favourite Pharma Major either positively or negatively
    • Worms in your favourite chocolate or a sudden war in the middle-east can impact the share price of some other Chocolate company or that of an Oil Marketing major.
  • If your single golden bullet misses its target, you're in doldrums.
  • On the contrary, if you are diversified across sectors, across geographies, across market-caps, etc., chances are bright that no single event is likely to significantly impact your overall portfolio performance - Your portfolio performance is, in that case, more likely to be influenced by your own overall efficiency of analysis, stock picking skills, etc.

Hence do make it a point to keep your portfolio diversified.

At least on this matter, don't listen to Warren Buffett blindly!



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