A note based on extracts from W. Buffet Letters.
"An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. In other words, diversification might be necessary to reduce the risk involved in the separate issues to the minimum consonant with the requirements of investment.
The instability of individual companies may conceivably be offset by means of thoroughgoing diversification.
There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.
A margin of safety does not guarantee an investment against loss; it merely guarantees that the probabilities are against loss. The individual probabilities may be turned into a reasonable approximation of certainty by the well known practice of “spreading the risk.” This is the cornerstone of the insurance business, and it should be a cornerstone of sound investment.
Pure Grahamites believe in wide diversification because in their worldview, while bad things can happen to a handful of portfolio businesses at the same time, the probability of bad things happening to all portfolio businesses at the same time is remote, thanks to the multiplication rule."
"An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. In other words, diversification might be necessary to reduce the risk involved in the separate issues to the minimum consonant with the requirements of investment.
The instability of individual companies may conceivably be offset by means of thoroughgoing diversification.
There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.
A margin of safety does not guarantee an investment against loss; it merely guarantees that the probabilities are against loss. The individual probabilities may be turned into a reasonable approximation of certainty by the well known practice of “spreading the risk.” This is the cornerstone of the insurance business, and it should be a cornerstone of sound investment.
Pure Grahamites believe in wide diversification because in their worldview, while bad things can happen to a handful of portfolio businesses at the same time, the probability of bad things happening to all portfolio businesses at the same time is remote, thanks to the multiplication rule."
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