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. 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 >>
  2. How is Warren Buffett Plan Bequeathing his Estate?

    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 >>
  3. 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 >>
  4. What's the largest charitable donation Warren Buffett ever made?

    Learn about Warren Buffett's biggest financial contributions and how his estate is to be divided between charity and Buffett's ... Read Answer >>
  5. What percentage of a diversified portfolio should be exposed to the utilities sector?

    Learn how investors determine how much of their diversified portfolio should be dedicated to utilities, a stable sector that ... Read Answer >>
Related Articles
  1. Small Business

    Questions For Warren Buffett

    What would you ask this legendary investor, especially if you were told you could only ask five questions?
  2. Investing

    The Best Books On Warren Buffett

    These six books aren’t as satisfying as owning Berkshire shares has been for the last 45 years, but there is a lot of knowledge and enjoyment in them nonetheless
  3. 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.
  4. Investing

    Think Like Warren Buffett

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

    Buffett's Early Days as a Value Investor

    Warren Buffett has been honing his investing process for years.
  6. Retirement

    Warren Buffett's Investment Lessons for Retirees

    For those in retirement, Warren Buffett's clear, timeless advice on investing is worth a look.
  7. 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.
  8. Managing Wealth

    Warren Buffett's Bear Market Maneuvers

    This esteemed investor rarely changes his long-term investing strategy, no matter what the market does.
  9. Managing Wealth

    Warren Buffett: How He Does It

    The Sage of Omaha has a careful methodology for evaluating value stocks.
RELATED TERMS
  1. Warren Buffett

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

    An investment fund that contains a wide array of securities to ...
  3. Sector Fund

    A stock mutual, exchange-traded or closed-end fund that invests ...
  4. Sector

    1. An area of the economy in which businesses share the same ...
  5. Passive Investing

    Passive investing is an investment strategy that limits buying ...
  6. Skin In The Game

    A term coined by renowned investor Warren Buffett referring to ...
Hot Definitions
  1. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  2. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  3. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  4. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
  5. Dilution

    A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...
  6. Agency Problem

    A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The problem ...
Trading Center