March 21, 2017

Warren Buffet: Diversification is a protection against ignorance

Billionaire investor Warren Buffett famously stated that "diversification is protection against ignorance. It makes little sense if you know what you are doing." In Buffet's view, studying one or two industries in great depth, learning their ins and outs, and using that knowledge to profit on those industries is more lucrative than spreading a portfolio across a broad array of sectors so that gains from certain sectors offset losses from others.

The problem with diversification, in the view of Buffett and other like-minded investors, is that even though risk is mitigated by sector gains offsetting sector losses, the opposite is also true – sector losses offset sector gains and reduce returns.

Buffett has amassed a fortune by acquiring incalculable knowledge about all things finance and about specific companies and industries, and using that knowledge to hand-pick his investments. Few investors have been better at picking stocks and timing entry and exit points. An ignorant investor – someone with little to no financial or industry knowledge – is bound to make blunder after blunder if he or she attempts to play the market the way Buffett does.

An investor who studies trends and has a keen understanding of how different companies and industries react to various market trends profits much more by using that knowledge to his or her advantage than by passively investing across a wide range of companies and sectors. Such an investor is able to go long on a company or sector when market conditions support a price increase; similarly, the investor can exit his or her long position and go short when indicators project a fall. The investor profits in either scenario, and those profits are not offset by losses in unrelated industries.

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