A:

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 need for diversification is a portfolio theory rooted in the idea that an investor who puts all his or her money in one company or one industry is flirting with disaster if that company or industry takes a dive. A famous example from the 21st century is the Enron scandal. Many employees of the ill-fated energy company were encouraged to invest their entire portfolios in company stock; when the company fell in 2002, these employees' savings were eradicated overnight.

Especially in the wake of scandals such as Enron, diversification is widely considered a part of investing basics. Personal finance courses teach it as gospel, deriding individual stocks as tantamount to casino gambling. In fact, many investors never even invest in an individual stock. Instead, they turn to mutual funds and exchange-traded funds (ETFs), both of which bundle hundreds of stock from various companies and sell them as a singular unit.

These traders further diversify by selecting mutual funds and ETFs from different sectors that follow different trends. Some follow the ups and downs of the broader market, while others remain relatively flat. Still others move inversely with the broader market, experiencing ups when most sectors are down and vice versa. The idea behind this strategy is that no matter what the market is doing, a portion of the investor's portfolio is likely to do well.

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.

RELATED FAQS
  1. Why does Warren Buffett largely avoid investing in the technology sector?

    Learn about why Warren Buffett has traditionally avoided investing in technology companies. Read about his value investing ... Read Answer >>
  2. How does Warren Buffett choose the companies he buys?

    Investors have long praised Warren Buffett’s ability to pick great companies to invest in. Lauded for consistently following ... Read Answer >>
  3. How did Warren Buffett get started in business?

    Warren Buffett may have been born with business in his blood. He started saving while other children were at the playground, ... Read Answer >>
  4. Why did Warren Buffett invest heavily in Coca-Cola (KO) in the late 1980s?

    Discover why Warren Buffett found Coca-Cola an attractive investment in 1987. One criteria of a Buffett stock pick is a moat ... Read Answer >>
  5. Does Warren Buffett invest in gold? Why or why not?

    Discover what Warren Buffett's investment stance is toward gold and silver, why he likes one of them a lot and the other ... Read Answer >>
  6. Who does Warren Buffett plan to bequeath his estate to?

    Find out how much Warren Buffett is leaving for his heirs and how he wants the funds invested after his death. Learn about ... Read Answer >>
Related Articles
  1. Investing

    Warren Buffett's Copycats

    The "Oracle of Omaha" is one of the most successful investors of all time. No wonder so many investors are mimicking his investments. Find out who Buffett's imitators are and how they're doing. ...
  2. Managing Wealth

    Rules That Warren Buffett Lives By

    The Oracle of Omaha has some words of advice that still ring rule.
  3. Investing

    Why Warren Buffett Envies You

    The Oracle of Omaha can move over - there's a new investor in town.
  4. Managing Wealth

    Buffett's Biggest Mistakes

    This investment guru is still human, and his biggest investing blunders prove it. Find out where he went wrong, and what you can learn from his mistakes.
  5. Investing

    Think Like Warren Buffett

    They don't call him "The Oracle" for nothing. Learn how Buffett comes up with his winning picks.
  6. Managing Wealth

    Warren Buffett's Bear Market Maneuvers

    This esteemed investor rarely changes his long-term investing strategy, no matter what the market does.
  7. Retirement

    Warren Buffett's Investment Lessons for Retirees

    For those in retirement, Warren Buffett's clear, timeless advice on investing is worth a look.
  8. Managing Wealth

    Warren Buffett: Oracle No More?

    Though he's an investing icon, critics are pointing to several past events that signal Buffett's reign may be ending.
  9. Investing

    Is Warren Buffet's Investment Strategy Suitable for Your Financial Profile?

    Learn about how investors may not be able to replicate Warren Buffett's value investing strategy. See how they can still easily follow Buffett's sage advice.
  10. Financial Advisor

    Markets Are Tanking: Time to Buy Like Buffett

    Learn about three value stocks Warren Buffett holds in his portfolio. See how Buffett uses market declines to find good deals on stocks.
RELATED TERMS
  1. Warren Buffett

    Known as "the Oracle of Omaha", Buffett is Chairman of Berkshire ...
  2. Sector Fund

    A stock mutual, exchange-traded or closed-end fund that invests ...
  3. Holdings

    The contents of an investment portfolio held by an individual ...
  4. Passive Investing

    Passive investing is an investment strategy that limits buying ...
  5. Sector ETF

    A class of exchange-traded fund that invests in the stocks and ...
  6. Sector Rotation

    The action of a mutual fund or portfolio manager shifting investment ...
Hot Definitions
  1. Leveraged Buyout - LBO

    The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. ...
  2. Current Assets

    A balance sheet account that represents the value of all assets that can reasonably expected to be converted into cash within ...
  3. Tax Liability

    The total amount of tax that an entity is legally obligated to pay to an authority as the result of the occurrence of a taxable ...
  4. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  5. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  6. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
Trading Center