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 does Warren Buffett choose his stocks?

    Investors have long praised Warren Buffett’s ability to pick great companies to invest in. Here are the key considerations ... Read Answer >>
  2. What was the first stock Warren Buffett ever bought?

    Learn some the important basic principles of investing illustrated by Warren Buffett's first experience in stock market trading. Read Answer >>
  3. 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 >>
  4. 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 >>
  5. What is Warren Buffett's annual salary at Berkshire Hathaway?

    Learn more about how much Warren Buffett receives in salary and how he continues to stay involved with his company and his ... Read Answer >>
  6. How did Warren Buffett get started in business?

    Warren Buffett may have been born with business in his blood, but it was a brush with Benjamin Graham that put him on his ... 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

    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. ...
  3. Investing

    The Best Books On Warren Buffett

    These six books aren’t as satisfying as owning Berkshire-Hathaway shares, but there is a lot of knowledge and enjoyment in them nonetheless.
  4. Investing

    Why Warren Buffett Envies You

    The Oracle of Omaha can move over - there's a new investor in town.
  5. Investing

    8 Ways to Think like Warren Buffett

    They don't call him "the Oracle" for nothing. Discover the eight extraordinary truth about how the legendary investor Warren Buffett comes up with his winning picks.
  6. Personal Finance

    Warren Buffett's frugal, so why aren't you?

    Warren Buffett, the Oracle of Omaha, has a net worth in the billions, but his lifestyle is not as rich as you may think.
  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. 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.
  10. Insights

    Warren Buffett: The Road To Riches

    Find out how he went from selling soft drinks to buying up companies and making billions of dollars.
RELATED TERMS
  1. Holdings

    Holdings are the securities within the portfolio of a mutual ...
  2. Diversification

    Diversification is the strategy of investing in a variety of ...
  3. Geographical Diversification

    Geographical diversification is the practice of diversifying ...
  4. Investing Sage

    An investor who is extremely knowledgeable about the markets ...
  5. Service Sector

    The service sector is the portion of the economy that produces ...
  6. Enron

    Enron was a U.S. energy-trading and utilities company that perpetuated ...
Hot Definitions
  1. Return On Equity - ROE

    The profitability returned in direct relation to shareholders' investments is called the return on equity.
  2. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  3. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  4. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  5. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  6. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
Trading Center