Conventional Diversification Makes No Sense!

(Continuation of the wonderful compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.)

Some investment strategies - for instance, our efforts in arbitrage over the years - require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment - one that indeed has a significant possibility of causing loss or injury - if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential.

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I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices.

Conventional diversification makes no sense for you.

Hmmm... what wonderful commonsense teachings, yet again!

Warren is very against diversification. He equates to holding many different stocks as being dumb and he advocates just to buying only five to ten sensibly priced companies that possess important long-term competitive advantages..... yup.... remember the durable competitive advantage thingy?

Here is a collection of some famous teachings on the issue of diversification.

Keynes...

’As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.’

Peter Lynch...

’The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four combined go nowhere, you’ve still tripled your money... The part-time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than five companies in the portfolio at any time.’

The crucial consideration is allowing enough time to be able to develop and maintain a high level of knowledge about each of the companies. ’Owning stocks is like having children--don’t get involved with more than you can handle.’ All stocks in the portfolio have to pass some stiff tests and you will not know if they pass the tests unless you are able to spend time analyzing them. The private investor simply will not have the analytical edge over Wall Street if he/she spreads intellectual resources thinly. The point at which you step over the boundary between investing in an informed way and speculating is different for each person:

’Maybe that’s a single stock, or maybe it’s a dozen stocks. ... There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors. That said, it isn’t safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios I’d be comfortable owning between three to ten stocks.’

Philip Fisher...

Everyone is aware of the horrors of putting too many eggs into one basked, says Fisher, but few people consider the ’evils’ of the other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put in them. Fisher regarded it as appalling that investors were persuaded to spread their funds between 25 or more stocks. The investor, or his adviser, is highly likely to be placing money in companies of which they know little. The result is that only a small proportion of the money is left for placement in companies of which they have a thorough understanding. ’It never seems to occur to them, much less to their advisers, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.’

Fisher draws an analogy with an infantryman stacking rifles to illustrate the degree of diversification needed. The ’stack’ would be unstable with just two rifles. Five or six, properly placed, would be much firmer. ’However, he can get just as secure a stack with five as he could with fifty.’ Fisher suggested that if the investor was focused on large well-entrenched growth stocks, then the minimum degree of diversification should be five such stocks--with no more than 20% in each. Also, there should be very little product line overlapping. If the focus is on companies that are more established than start-up technology stocks, but are not yet leading and well-entrenched growth stocks, then the investor should not put more than 8-10% of funds in each. Also, never put more than 5% of assets into a single very small company.

Fisher advised that investors should only add more securities to their portfolio if they can keep track of all the company events, strategic conditions, management quality and a host of other factors about each company: ’Practical investors usually learn their problem is finding enough outstanding investments, rather than choosing among too many... Usually a very long list of securities is not a sign of the brilliant investor, but one who is unsure of himself. If the investor owns stock in so many companies that he cannot keep in touch with their management directly or indirectly, he is rather sure to end up in worse shape than if he had owned stocks in too few companies. An investor should always realize that some mistakes are going to be made and that he should have sufficient diversification so that an occasional mistake will not prove crippling. However, beyond this point he should take extreme care to own not the most, but the best. In the field of common stocks, a little bit of a great many can never be more than a poor substitute for a few of the outstanding.’

And this was taken from Mary Buffett's first book, Buffettology (chapter 26).

The Myth of Diversifications Versus the Concentrated Portfoilio.

Buffett believes that diversification is something people do to protect themselves from their own stupidity!

They lack the intellegence and expertise to make large investments in just a few businesses, so they must hedge against the folly of ignorance by having their capital spead out among many different investments.

This theory was based upon Graham's investment strategy that required literally one hundred or more stocks in his portfolio to hedge against the possibility that some of his investments might never perform, as businesses and as stocks. For Graham was locked into the numbers and not concerned with really what was going on in the businesses he owned.

Well, Buffett did follow his mentor for a while but in the end, he found the going tough as he felt that it was more like owning a zoo than a stock portfolio. He then switch to Munger/Fisher format in which he invested with a business perspective.

Fisher, though agreeing that some diversification was necessary, thought that diversification, an investment principal, was oversold. He pointed out that some cynics thought this was because it was a simple enough theory for even some stock brokers to understand. Fisher agreed that investors, responding to the horrors of putting all their eggs into basket, ended up spreading out their eggs into dozens of different baskets, with many of the baskets ending up containing broken eggs. And it was also impossible to keep an eye on all the eggs in all the baskets. Fisher thought that most investors were simply oversold on this idea of diversification that they ended up owning so many stocks that they had little or no idea of what kind of businesses they had invesed in.

Buffett was greatly influenced by the late Keynes who made the majority of his money in just a few investments - the underlying businesses whose investment value he understood.

And as such, Buffett had adopted the concentrated portfolio approach, which means he holds a small number of investments he really understands and intends holding for a long period of time. This allows the question of whether to allocate capital to an investment to be approached with the utmost seriousness. He believes that it is the seriousness with which he addresses the questions of what to invest in and at what price dcreases the risk. It is his commitment to the strategy of investing only in exceptional businesses at prices that make business sense that reduces his chances for loss.

Warren has often said that a person would make fewer bad investment decesions if he were limited to making just ten in a lifetime. Just ten. You would have to put a little work into making those ten decisions, don't you think?

Bernard Baruch, the guy who made tons of money during the 1901 crash, said: "Time and energy are required to keep abreast of the forces that may change the value of a security. While one can know of all there is know about a few issues, one cannot possibily know all one needs to know about a great many issues".

and i of course like these comments the best...

Warren Buffett...

Buffett likens a portfolio of 40 or more stocks as a Noah’s Ark way of investing--you end up with a zoo. Another metaphor is attributed to Billy Rose, the Broadway impresario, ’If you have a harem of 40 women, you never get to know any of them very well.’ At the end of 1999 and 2000 Berkshire had 70% of its investment funds in just four companies. Buffett and Munger concentrate their attention, skills and experienced judgment because it is ’too hard to make hundreds of smart decisions.’

This attitude flies in the face of standard portfolio theory dogma. Critics say that this will lead to a very risky portfolio. Buffett disagrees: ’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.’

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(LOL!!! If you have a harem of 40 women, you never get to know any of them very well! Better not let me Granny read this line! And I hope she did not hear about Lynch's comments that owning stocks is like having children--don’t get involved with more than you can handle!!! :P )

So how many stocks do you own?

Are you owning too many stocks?

Remember the last underlined saying, "too hard to make hundreds of smart decisions". And in that sense if we own about 30 stocks, this would mean that we would need to make 30 really intelligent investing decisions. And logically this would increase the chances of us making a couple of not too smart investment decisions. And such not too smart investment decisions really equates to poor investments which equates to investment mistakes. And mistakes simply costs moola!

Remember by concentrating only on a few handful of stocks, it allows the investor to be more focus and it eliminates the chances of the investor making poor investment decisions due to lack of focus.