Does Warren Buffett Really Practice What He Preaches About Diversification?

Warren Buffett is an all-star on Wall Street; every word he speaks is treated as if it has come from on high. There’s a good reason for that, given that Buffett’s Berkshire Hathaway (BRK.A 0.13%) (BRK.B 0.15%) has dramatically outperformed the S&P 500 index over the long term. But you need to take even this sage’s advice with a grain of salt. That’s particularly true when it comes to diversification.

What Buffett has said about diversification

The so-called Oracle of Omaha didn’t mince words with his comments on diversification, which is a tried-and-true investment tactic. In short, he came out against the practice, explaining that, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” That’s pretty rough and might even hit at the ego of some investors, most of which would like to think they know what they are doing.

Image source: The Motley Fool.

To Buffett’s credit, when it comes to Berkshire Hathaway’s individual stock portfolio, he lives by his words. At the end of 2023, the company noted that 79% of its investments in equity securities was concentrated in just five companies: American Express, $28.4 billion; Apple, $174.3 billion; Bank of America, $34.8 billion; Coca-Cola, $23.6 billion, and Chevron  $18.8 billion. Each of these investments has been a fairly big success story over the long term, noting that Apple’s value was just $119 billion a year earlier. (Note also that Buffett has been trimming his Bank of America position of late, but it still remains a very large holding.)

The logic is pretty simple here. If you pick a small number of good stocks you can quickly compound your wealth. That’s just math, since every new stock you add to your portfolio risks diluting the overall return if it isn’t a huge winner. And there are only just so many big winners on Wall Street. The problem is that most people probably won’t be able to pick just the winners, which is why diversification is so important. It limits the pain from the inevitable investment mistakes that everyone makes (even Warren Buffett).

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Don’t be fooled; Buffett believes in diversification

For starters, Buffett has said that most investors would be better off buying a broad-based index fund. So his somewhat caustic words about diversification should be taken with a grain of salt. He’s most likely speaking about professionals that spend all of their time investing, not small do-it-yourself investors that are trying to balance a job, family life, and investing. But there’s one more little fly in the diversification ointment at Berkshire Hathaway.

If you take the time to read Berkshire Hathaway’s annual report, you’ll find something fairly unique under the section titled Business Description. This is usually the first thing in an annual report, and it normally takes up less than a single page. For some companies it’s just a single paragraph. For Berkshire Hathaway the business description runs for more than 20 pages.

The issue isn’t that Berkshire Hathaway’s primary business is so complex that it needs that much space to be explained. The reason that the business description runs 20 pages is that Berkshire Hathaway’s portfolio of owned businesses is huge and, wait for it, shockingly diverse.

The core operation is the company’s insurance arm. But its railroad, utility, and energy operations are so large that they actually get broken out in the financial statements. Right there the company is diversified across four large and very different businesses. However, there’s a lot more going on beyond that, including businesses in the manufacturing, housing, retail, chemical, and automotive sectors, among others. The list of businesses Buffett has acquired is so extensive that it really does take more than 20 pages to cover.

The key is in the way Buffett invests

You could play this off as different from investing because Berkshire Hathaway owns the businesses and isn’t investing in their stocks. That’s true, but you have to understand how Buffett operates Berkshire Hathaway, which is effectively just his publicly traded investment vehicle. He is doing the same thing he does with stock holdings, acquiring well-run businesses while they appear attractively priced, only he’s buying the entire company. So in effect Berkshire Hathaway is kind of like a giant mutual fund. And the portfolio of owned business is, in many ways, treated no differently than the individual stocks in which Buffett invests.

The big takeaway for investors is to do as Buffett does, not as he says. Yes, if you pick one great stock it could make you rich. But even Buffett uses a diversified approach when it comes to operating Berkshire Hathaway. You should do that with your portfolio, too.