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Consider a company that owns two stores, one that sells expensive clothes and one that sells discounted merchandise Pro t margins are usually higher for expensive clothes When the economy is doing well, the expensive clothing store will yield higher pro ts, not only because of pro t margins but also because of sales volume However, when the economy is in a recession, the upscale clothing store may become a burden But remember that the company also owns the discount store, which does well in a recession The pro ts from the discount store act as a cushion during the recession Without diversi cation, the company can incur enough large losses to cause permanent damage to the business Investing in stocks is investing in businesses If you owned shares of Abercrombie & Fitch stock, your fortunes would be tied to the successes of that store s fashionable goods However, if you also owned Wal-Mart stock, you would be somewhat protected from the idiosyncratic habits of the high-fashion teenagers who shop at Abercrombie & Fitch Owning more than one stock is the rst step toward diversi cation Beyond holding Abercrombie & Fitch and Wal-Mart, if you also owned Intel or IBM, you would be even more diversi ed The basic goal of diversi cation is to protect your investments from unpredictable events Diversi cation is an insurance policy When you do not diversify and put all your funds into the stocks of one or two outstanding companies, you can easily end up losing a lot of money if one company faces unforeseen dif culties If you diversify by investing in 10 outstanding companies, you are likely to see good results even if a few of those companies do not do well On the other hand, if you diversify a lot, you may end up with approximately the same returns as the market So, how many stocks should you invest in Before we can answer this question, let s examine what Buffett has done at Berkshire Hathaway
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How Diversi ed Is Berkshire Hathaway
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At the end of 2008, out of Berkshire s total assets of $267 billion, $55 billion was invested in common stocks of various companies The largest investment $91 billion was in Coca-Cola Other large equity investments included Well Fargo ($9 billion), Procter & Gamble ($58 billion), ConocoPhillips ($44 billion), and American Express ($28 billion) Berkshire s equity investments are concentrated in only a few companies We should think of diversi cation on at least two levels at the level of the company s total assets and then at lower levels such as the company s equity portfolio Out of Berkshire s total assets of $267 billion, only $55 billion or 21 percent are invested in common stocks This implies that the company can have a reasonably high level of concentration in its equity holdings and still be well diversi ed In particular, the ve largest holdings mentioned here made up more than 50 percent of Berkshire s equity portfolio but only 11 percent of its total assets These seemingly concentrated equity holdings are actually not very concentrated, as Berkshire as a whole is well diversi ed Buffett invested heavily in Coca-Cola in 1989 1999 At the end of 1999, the market value of the Coca-Cola investment alone at $17 billion was 18 percent of Berkshire s total assets of $95 billion Buffett invested heavily in Coca-Cola because he was con dent in its future Ten years later, at the end of 1999, the Coca-Cola investment was worth $117 billion Berkshire made a much smaller investment of $244 million in 2008 in two Irish banks, which went down by 89 percent within the year Buffett invested a very large sum in Coca-Cola but only a small amount in Irish banks The main lesson is that the lower your con dence in the future performance of a stock, the less you invest in that stock
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