According to Forbes, Warren Buffett is the third richest person in the world. His net worth stands at just under $61bn, which isnt bad when you consider he has made the lions share of it through passive investing. In other words, Buffett has not come up with a particularly revolutionary or world-changing idea throughout his whole career. Rather, he has found the right businesses and backed them with his own money. However, while he has been stunningly successful, he could have one major weakness.
At the end of September 2016, Berkshire Hathaway held shares in a total of 48 companies. While this may sound like a diversified portfolio, almost 70% of the total amount invested was held in just five companies. In fact, the biggest holding in the portfolio, a $29bn position in Heinz, amounted to over 20% of the entire amount invested.
This means that Berkshire Hathaway is highly concentrated in a small number of stocks. Should one or more of the biggest holdings release a profit warning, or endure a disappointing share price performance, the reality is that the overall portfolio will be hit hard. This goes against the general advice for investors to diversify among a relatively large number of stocks, which reduces the company specific risk associated with investing.
As a result of its limited diversification, Berkshire Hathaways portfolio would generally be considered high risk. Of course, all shares carry a degree of risk and the biggest holding, Heinz, is a relatively low risk company due to its focus on food production. However, even the lowest risk of companies can endure difficult trading conditions, or make the wrong decisions on strategy. Furthermore, there is an ever present danger that investors will focus on other sectors, or even on higher risk stocks, which could lead to a period of underperformance for Heinz or similar stocks.
Clearly, Berkshire Hathaway has been successful and Buffett has adopted a strategy of buying a small number of stocks which he backs heavily. This strategy may be risky, but if the stocks selected perform well then it can lead to exceptionally high portfolio returns. Therefore, while risky, it is also potentially highly rewarding.
However, this doesnt mean that the strategy should be followed by private investors. For starters, Warren Buffett has shown an exceptional skill for stock picking over a prolonged time period. Therefore, the chances are that he will be able to outperform the majority of private investors over the coming years.
Furthermore, Buffett has a large amount of cash on hand at all times and so it doesnt matter if his investments underperform for a few years. He will still be able to pay his bills with room to spare, which may not always be the case for private investors especially those who rely on their portfolio for an income. As such, diversification remains crucial, even if the most successful investor in the world seems to avoid it.
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