Last Updated on April 26, 2022 by Rational thinking
Warren Buffett, the Oracle of Omaha, has been a strong advocate of buying only what you truly understand and only companies where you can estimate future earnings with a certain degree of accuracy. This requires that you only invest in companies that are within your circle of competence. I guess all of this is well known to all investors.
But what is perhaps less known is that Buffett has a simple heuristic to avoid “diworsification”:
When you have money to invest, first look at investment opportunities in companies you already own.
This very simple rule makes a lot of sense. Let me summarize why this advice is underrated:
Circle of competence:
Given you have done proper research and due diligence before you bought a stock, you probably have a deep understanding of why you own the stock. Nothing beats the power of having skin in the game! This way you more than likely have a better understanding of stocks you own compared to stocks you don’t own.
Because of this, it’s very useful to write down the reasons why you invest in a company (before you invest, obviously).
Knowledge of the company and its management:
There is truly only one way to get to know a company really well: by following it over many years. This way you can look at its management, operational performance, how it lives up to its promises and how capital is allocated. By regularly reading the reports, both annual and quarterly, you develop knowledge as you own it. The longer you are an owner, the more knowledge you develop.
Why invest in your 15th best idea rather than your best idea? The main reason is usually a lack of self-confidence and an urge to reduce “risk” by diversifying into more stocks. However, the best money managers run mostly small portfolios just of 7-15 stocks. And this makes sense: The diversification effect kicks in at 15 stocks. Any higher number of stocks and you increase the likelihood of mediocre/average performance. To diversify for the sake of diversifying is not a good idea.
My own personal experience:
Up until 2015, I invested mainly in mutual funds and only occasionally directly into stocks. I was busy daytrading and didn’t allocate much time to invest, but over the years I developed a small portfolio of nine stocks. My main circle of competence was around my own experience as a user of a company’s products, and when I finally found an interesting company I spent some time looking at the fundamentals. This simple method turned out to work pretty well.
After 2015 I gradually spent less time on daytrading and more on long-term investments. However, my statistics show I would perform better by simply adding to my previous investments instead of diversifying into a broader base of stocks. I have simply lowered my performance and “diworsified”.