This Is the Driving Factor Behind Warren Buffett's Investing Success

Each year, tens of thousands of investors flock to Omaha, Nebraska, to witness the spectacle that is the Berkshire Hathaway annual shareholder meeting.

These investors make the trek to witness chairman and CEO Warren Buffett impart precious nuggets of financial wisdom.

But there is often a point of contradiction between Buffett’s public investing advice and the approach he takes as a professional money manager.

© The Motley Fool Warren Buffett, smiling at an annual shareholders meeting.

For example, Buffett has long touted the importance of indexing, saying, “I think that the best thing to do is buy 90% in an S&P 500 index fund.” But when you look at Berkshire Hathaway’s equity holdings, you’ll see a highly concentrated portfolio of individual stocks.

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So, this begs the question: Why does Buffett tell the public to invest one way, while he’s doing essentially the exact opposite?

The answer lies in understanding the type of investor you want to be.

Buffett’s history of portfolio concentration

For about as long as Buffett has invested money professionally, he’s run a highly concentrated portfolio.

“We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it,” Buffet once stated.

Here’s a look at how concentrated his investments have been throughout the years.

Year

Berkshire Hathaway’s Top Five Holdings as Percentage of the Portfolio

1985

89%

1990

93%

1995

77%

2000

75%

2005

66%

2010

62%

Data source: Berkshire Hathaway annual reports. Chart by author.  

This year is no different. According to Berkshire Hathaway’s latest 13F filing, here’s how the top five holdings are currently broken down:

Company/Ticker

Percentage of Portfolio

Apple

39%

Bank of America

10%

Coca-Cola Co.

8%

Chevron 

8%

American Express

7%

Total

72%

Data source: Berkshire Hathaway 13F public filing. Chart by author. .

While this approach seemingly flies in the face of everything you’re taught about diversification, you cannot argue with the results.

Through 57 years of investing, Berkshire Hathaway’s stock has appreciated at a 20% compound annualized rate of return, which nearly doubles the annualized return of the S&P 500.

Why Buffett isn’t wrong to promote index investing

While it feels a bit disingenuous for Buffet to not practice what he preaches, there’s a perfectly good explanation for why he frequently promotes indexing as opposed to concentrated bets in individual companies. The reality is that most people will not be willing to invest the time or the energy to research and understand businesses.

Buffett understands people want results with minimal effort. If that’s the case, there’s no better option than index investing, where you can grow life-changing wealth over the long run with next-to-no research.

© YCharts ^SPX

Why stock picking is still a worthwhile venture

While index investing is an effective means of building wealth, there’s very little opportunity for intellectual growth. You’re not likely going to conduct any meaningful research into the companies within the index.

And that’s really the beauty of buying the entire market. With little to no research, you can be a participant in the greatest wealth-building machine on the planet: the U.S. stock market.

But if you’re interested in growing as an investor both intellectually and emotionally, you need to at least dabble in stock picking. You’ll make plenty of mistakes along the way, but those errors will make you a better investor.

One of my favorite Warren Buffett facts is that he made roughly 90% of his wealth after the age of 65. This is an incredible testament to the power of compounding, but not just in a financial sense. I’d like to think Warren’s business knowledge and his ability to identify great companies trading at reasonable prices also snowballed over those 65 years.

It’s obvious that Warren Buffett is a generational talent when it comes to stock picking. This is likely why he is comfortable with such concentration in his holdings. But you don’t have to be a genius to identify and buy high-quality companies.

Doing so is not likely to make you a millionaire (let alone billionaire) anytime soon, but it will teach you about business and how to distinguish the good ones from the bad ones. Like with everything, the more you do it, the better you’ll get.

If you aspire to be better than average, consider not just what Buffett says, but also what he does.

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Bank of America is an advertising partner of The Ascent, a Motley Fool company. American Express is an advertising partner of The Ascent, a Motley Fool company. Mark Blank has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), long January 2024 $47.50 calls on Coca-Cola, long March 2023 $120 calls on Apple, short January 2023 $200 puts on Berkshire Hathaway (B shares), short January 2023 $265 calls on Berkshire Hathaway (B shares), and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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