Many investors think diversifying their investment portfolio across various assets based on an asset allocation formula reduces risk and potential losses. The reasoning is that gains in some investments can offset losses in others. But Warren Buffett and Charlie Munger challenge this common approach. "One of the inane things that is taught in modern university education is that advanced diversification is absolutely mandatory in investing in common stock", Charlie said.
Diversification is usually practiced alongside asset allocation. Investment is spread across different assets, such as individual stocks, bonds, real estate, cryptocurrencies, commodities, and a basket of securities, such as ETFs, mutual funds, and REITs. The percentage of a portfolio allocated to a particular asset class is usually determined by the investor's risk profile. Aggressive investors might allocate 80% of their portfolio to stocks or cryptocurrency, and the remaining 20% to bonds. Conservative investors might allocate 70% to less volatile assets, such as fixed-income securities or real estate.
Correlation between the sector and industry, and market capitalization is also considered. High-growth industries like technology are very volatile, but they can generate huge returns when things go right or huge losses when things go south. Established companies, on the other hand, are stable and safe, but they cannot generate huge returns on investment. The correlation between the assets must be low. An event that negatively affects one asset should have positive effects on another. For example, commodities like gold usually rise when the stock market declines. Warren and Charlie believe this is a wrong way to diversify an investment portfolio.
Having a portfolio with an asset allocation rule that allocates 30% to the stock market or 20% to bonds makes no sense to Charlie. "I am only interested in investing where I have some sort of advantage...and if I have the advantage in three different things, that's enough" Charlie said. His rationale is that an investor will have few investing ideas where the odds are in your favor. In such a situation, limiting your investment due to an allocation rule is not the best course of action. Two past events illustrate how Warren Buffett put this advice into practice. In the early 1960s, American Express (AMEX) was involved in the financing of Salad oil. AMEX was tricked into guaranteeing 1.3 billion pounds of Soyabean Oil, even though only 134 million pounds was stored.
The scam was uncovered by authorities and AMEX was potentially liable for $135 million. Investors fearfully dumped AMEX’s shares, sending it from a high of $62 3/8 to a low of $35. “American Express had over eighty percent of the traveler’s-check market nationally, and nothing could shake it”, Warren said. To confirm this, he went to Ross’s Steak House in Omaha to see how many American Express vouchers customers used. He drove to multiple banks in Omaha to see whether the scandal had dampened customer’s confidence and affected the sale of AMEX traveler's checks. Despite the scandal, AMEX remained a strong franchise, and its shares were grossly undervalued.
Warren went all in. He bought close to 5 percent of the company, which was around 40 percent of his partnership holdings. AMEX went from $35 to $189 in the following five years, netting a huge return for the fund. In his January 1967 letter to partners, Warren wrote, “Our relative performance…was the best we have ever had - due to one holding which was our largest investment at year end 1965 and also year end 1966. This investment has substantially out-performed the general market for us during each year (1964, 1965, 1966) that we have held it…The attractiveness and relative certainty of this particular security are what caused me to introduce Ground Rule 7 in November, 1965 to allow individual holdings of up to 40% of our net assets. We spend considerable effort continuously evaluating every facet of the company and constantly testing our hypothesis that this security is superior to alternative investment choices.” Similarly, Berkshire Hathaway previously owned around 5% of Apple Inc., which was a significant portion of Berkshire's portfolio at the time. In response to a question about Berkshire's portfolio not being diversified, Warren said, “Our criteria for Apple is different [from] other businesses we own; it just happens to be a better business than any we own and we put a fair amount of money in it... Our railroad is [a] very good business but it's not remotely as good as Apple's business.”
According to Market Sentiment, Berkshire would have significantly lagged behind the market between 2016 and 2023 without investing in Apple. Without Apple -- Berkshire: 142% | S&P 500: 168% With Apple -- Berkshire: 174% | S&P 500: 168% In the 2024 Annual Letter to Shareholders, Warren said, "And our experience is that a single winning decision can make a breathtaking difference over time." This is evident in Berkshire's 20 years performance between 2004 and 2023. The company would have significantly underperformed the market without Apple: Without Apple -- Berkshire: 442% | S&P 500: 537% With Apple -- Berkshire: 542% | S&P 500: 537%
One of the most compelling advantages of investing like Warren and Charlie is that you only need to invest when you have an advantage. You wait till the odds are in your favor. "The most important thing in hitting is waiting...People can throw Microsoft at me, and you name it, any stock, General Motors, and I don't have to swing...So I can wait there and look at thousands of companies day after day, and only when I see something l understand and when I like the price at which it's selling, then if I swing, if I hit it, fine. If I miss it, it's a strike, but it's an enormously advantageous game", Warren said.
Rather than investing using a rigid asset allocation approach, investors should focus on their best investment opportunity. Whether such opportunity is in the stock market, the bond market, or real estate is irrelevant. What is pertinent is that the opportunity is superior to alternative investment choices. Once you recognize such opportunity, invest a substantial amount of money. However, not everyone can follow this approach, as some investors cannot distinguish when an investment opportunity is superior. Many investors fall into this category, and Warren advises them to invest in a low-cost index fund, such as the S&P 500, rather than following a formulaic asset allocation approach which will likely underperform the market in the long run.