"Diversification is protection against ignorance," Buffett said. "It makes little sense if you know what you are doing."

I hear this quote a lot from investors. They are typically young and male and very confident. Take that how you may.

Their interpretation of this quote is unambiguous. They will run concentrated portfolios and this approach will make them rich. Diversification is for the ignorant and they are far from ignorant. And none other than the oracle of Omaha is backing their approach.

I will start off by saying that I’m a fan of Warren Buffett. Not exactly a novel concept. I’ve read a lot about the concentration in Berkshire Hathaway’s portfolio. On the surface this is hard to argue. Berkshire holds around $350B in publicly traded securities. Around half of that is in Apple (NAS: AAPL). 65% is in the top three holdings which include Bank of America (NYSE: BAC) and American Express (NYSE: AXP). 78% is in the top 5 holdings which include Coca Cola (NYSE: KO) and Chevron (NYSE: CVX).

The publicly traded shares that Berkshire owns is only a small part of the business. Berkshire also has 72 different companies (at last count) under their umbrella which are fully owned. The company is more diversified than the publicly traded shares indicate.

More importantly the people who tell me about this quote are not Warren Buffett. Neither am I. And neither are any of the people reading this article. This article will explore the quote and the different approaches investors can take.

Diversification vs concentration

Mathematically the way to have the most money is to pick the share that will perform the best and put all your money into that share. This is obviously easier said than done.

And Buffett isn’t alone talking about concentration. There are several other quotes and studies looking at how wealth is accumulated. These show that the wealth of most self-made individuals comes from concentrated holdings in a single company. The important caveat is that the people that have amassed this wealth in a single company have generally either started the company or control it.

There are large differences between founders and / or controlling shareholders and minority shareholders who invest in the share market. A source of investing edge is informational advantage. That means one way of outperforming other investors is to know something that other investors don’t know. Seems obvious. 

Over the years significant amounts of regulation aimed to eliminate informational edge for minority shareholders. This has largely been successful. There are rules about what information a company can disclose and how they disclose it. This ensures equal access to information for all shareholders. 

These rules don’t impact a majority shareholder who still runs a company. They obviously know more about the company than an investor that doesn’t work for the company. Their position in the company means they should know more about it than other employees. The fact that they started and grew a successful company means they know the industry and the competitive dynamics better than many other people.

The level of knowledge about a company varies among minority shareholders. Some do extensive research and keep up to date with the company and the overall industry. They understand the factors that impact performance. Conversely, some ‘investors’ just take a punt on a ticker symbol recommended by a mate. 

I’m an advocate for knowing about the companies in your portfolio. However, it is important to acknowledge that no amount of study or work will allow any minority shareholder to know everything about a company.

Famously six weeks before Enron’s bankruptcy 12 out of 15 analysts rated the shares a “strong buy.” Enron was obviously a unique case. The publicly released information on Enron was manipulated by management.

Some accounting experts believe there were red flags that should have been caught. Some say it is next to impossible to catch deliberate fraud. The larger question for each investor is do you have the knowledge, time and temperament to identify issues in financial statements and go against the crowd and act on your suspicions? I know I don’t.

Fraud is not the only risk an investor faces. There are too many to count. We’ve recently gone through a global pandemic that shut down large parts of the economy. Very few people imagined that scenario.

There are risks inherent in investing that are hard to imagine eventuating because it is often a combination of disparate factors that bring about trouble for a company. War, new technology, management greed and poor decision making are all examples. If something can go wrong to a company, at some point it will. 

How to protect against risk

An investor gains protection from single security risk through diversification. Single security risk covers all those one-off scenarios I raised above. The more a portfolio is diversified the less that single security risk will impact the performance of a portfolio.

This is a balancing act. At some point a portfolio of single companies becomes so diversified it starts to look a lot like an index. There is nothing wrong with owning an index. However, the cost and trouble of maintaining a portfolio that will perform like an index makes it better to just buy the index. 

Where the happy medium exists with diversification is based on the individual situation of each investor. I’ve decided 5% is the absolute limit I would have in a single share. If that position went to zero I would still be able to accomplish my goals. Other investors may come up with different conclusions.

Running any portfolio made up of individual shares takes time, effort and knowledge. And Warren Buffett recognises this and has said again and again that most investors should just buy low-cost index funds. A bit of a different take than his quote about concentrated portfolios.

My own lesson about risk

I learned the downside of concentration during the global financial crisis. The largest position in my portfolio going into 2007 was Citigroup (NYSE: C). And large is a bit of an understatement. It made up more than 15% of my portfolio.

A little background to how I found myself in this situation. My father-in-law spent his whole career at Citigroup. He was generous enough to give my wife a couple shares each year as a Christmas present. Over time these shares appreciated significantly. We got married and combined finances and there it was – 15% of our portfolio in a single company.

I knew this was a bad idea. I would never build a position that large in my portfolio. And obviously I could have easily fixed the problem. I could have rebalanced which we covered in a recent episode of Investing Compass. 

The issue I confronted was that the shares had a very low-cost base. And I did not want to pay the taxes on the capital gains.

Knowing I was doing something wrong but wanting to avoid the downside of fixing it I did something that many of us do. I reasoned and justified my way out of my conundrum. My first justification was that I was young and I could fix this problem with time. I would save and invest more and that would slowly dilute the position. And this approach probably would have worked. The problem is I didn’t have the luxury of time.

Going into 2007 the US housing boom was going full steam. And I knew something wasn’t right. The signs of excess were everywhere. And while I didn’t short the market and end up as a character in Michael Lewis’ book I was at the very least attuned to the risk.

I knew that banks like Citigroup were underwriting and buying mortgages to securitise them. This gave me confidence that if something went wrong and people started to default it wouldn’t matter because the mortgages had been sold. A little bit of knowledge can be dangerous when it increases confidence. Especially when it is incomplete and masks the risk. 

I justified my actions with the fact that Citigroup wasn’t an investment bank. It was a commercial bank with operations all around the world. Securitising mortgages was only a small part of their operations. The final factor that gave me confidence was that this was Citigroup. One of the largest banks in the world. Run by smart people and a sophisticated risk management team. Robert Rubin worked there who was a former Treasury Secretary. What could go wrong.

It turns out a lot. The bank did securitise the mortgages and sold them to investors. That got them off the books. The detail about creating collateralised debt obligations (“CDOs”) is unimportant. The important point is that they kept the riskiest parts of the bonds they created because nobody else wanted to buy them. They were willing to take on the risk because that is the only way they could earn the fees for creating the CDOs. Citigroup set up off balance sheet entities as a dumping ground.

They also held a lot of the mortgages on their balance sheet to warehouse them while they created the CDOs. Eventually 80% of these mortgages would default.

My assumption about a competent risk management function? I was partially right. Multiple risk officers raised red flags and warned senior management and the board about what was happening. At least someone identified the risks. The problem was that everyone that raised the alarm was all demoted or fired.

The follow chart shows the run up for Citigroup that created those capital gains. It also shows the cliff that Citigroup and 15% of my portfolio fell off. Obviously not ideal. The only thing I managed to accomplish by my mistake was avoiding those capital gain taxes. Turns out there aren’t many capital gains when a share goes down 97% in 18 months.

Citigroup chart

There are lots of lessons here. I’ve changed my investment approach and focus on companies that are easier to understand. It is very difficult to know all the risks lurking on the balance sheet of a bank.

Yet my mistake did not arise from ignorance alone. I may not have known the risks lurking on Citigroup’s balance sheet. I did know the risk from having such a large position in a single share. The fact that I spent so much time justifying my lack of action attested to the fact I knew I was doing something wrong. In a different world I likely would have gotten away with it. That didn’t make it smart.

Life has a way of humbling everyone. All you can do is learn from your mistakes and move forward. Hopefully some readers of this article will learn something from my experience and not make the same mistakes.

Buffett is right to point out that ignorance is not a trait that leads to successful investing outcomes. We should all strive to understand as much as possible about any investment in our portfolios. But we need to retain a sense of humility. Even the most informed investors will not know everything going on within a company. No amount of imagination can foresee the risks arising from the unpredictability of life. Avoid diversification at your peril.

How do you view concentration? Let me know at [email protected]