Warren Buffett On Diversification

Reader “sumflows” uploaded this video from Warren Buffett’s speech at Florida that discussed Buffett’s advice on diversification, and the best part about it is that Buffett gives advice based on the particular goals that leads each person to investing in the first place.

http://www.youtube.com/watch?v=wbjPiYE-F4Y&feature=youtu.be

If you are someone that is making $9,000 per month post-tax and is only spending $6,500 of it, and you don’t have a particular desire to spend a lot of time studying individual companies, then it makes a lot of sense to open up an account with Vanguard and funnel the money into the S&P 500 Index Fund each month that barely costs anything in fees (the expense ratio for “VFINX” is 0.17%, meaning you would have to pay $17 each year on every $10,000 you entrust to this S&P 500 Index Fund run by Vanguard).

The first of the two main advantages with this strategy is that if you only have a moderate interest in investing, you don’t have to spend a whole lot of time worrying about investments. Your focus is making money, spending less than you earn, and then doing the things you enjoy. For the person that doesn’t take on investing as a serious hobby/lifestyle choice, index funds are great options.

The other advantage of index investing is that you don’t have to deal with company specific risk. When long-time General Electric shareholders saw a $40 share price quickly turn to the $6-$12 range, they had to make a discerning decision to determine why it would make sense to buy or hold GE stock compared to, say, Wachovia which had similar risk profile elements but did not survive.

With an S&P 500 fund, you can feel comfortable socking more money after a 30% decline because you are only betting on a general economic recovery: that Exxon will sell more gas 10 years from now, Microsoft will sell more Software, Apple will sell more phone, Pfizer will sell more prescription drugs, Johnson & Johnson will sell more Tylenol, McDonalds will sell more cheeseburgers, and so on. It’s a more general bet on the future of American and global commerce, and that can make committing more money after a steep drop easier.

For investors that take things seriously, I get where Buffett is coming from when he says that someone should only own six stocks. If I had to guess which companies would still be paying out dividends a century from now, I’d bet on Johnson & Johnson, Colgate-Palmolive, Nestle, Exxon, Coca-Cola, and Disney. It’s very reasonable to think that any portfolio I construct over my lifetime will deliver inferior results than a portfolio that consists solely of those six companies.

Knowing this, why wouldn’t I want to proceed differently? Because if I’m wrong in a big way, I could lose 17% or 33% of my capital fairly quickly. I’d feel a lot better throwing General Mills, Procter & Gamble, Pepsi, Chevron, Kraft, and some others into the mix to hedge myself against unforeseen events. I’d rather build a collection of the best businesses I can find than try to eke out that extra 1-3% of portfolio return (by the way, that 1% or 2% adds up over a long period of time, but then again, who knows? P&G could outperform Disney over the next 50 years, so hedging could end up having an “improving” effect overall).

I think there are fifty or so truly excellent businesses in the world, and I’d rather spend my time gradually accumulating each of them rather than splitting hairs about trying to figure out whether Exxon or Chevron is better. I think “both please” is the right answer.