Diversification vs Concentration: Why Buffett HATES Diversification.

Warren Buffett and Charlie Munger HATES diversification…

Watch the video and understand why…

video

According to Buffett, “Diversification is a protection against ignorance,” and it makes very little sense for those who know what they’re doing.

Many big name investors such as Buffett, Munger and Soros in the past voiced against diversification.

On the other hand, conventional wisdom suggest that diversification is key to investing success.

Who should you follow…?

Don’t put all your eggs in one basket – diversify?

Or…

Put all your eggs in one basket and watch them closely?

If you are still stuck with these questions and wondering to yourself – don’t worry for you are not alone…

Hopefully by the end of this post, you will have a better picture of what suits you best and the trade-offs between the 2 school of thoughts.

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The Go-To Advice…

Diversification has its obvious benefits but you need to balance the trade-off between risk-controls and returns. Diversification reduces both systematic risk and volatility but limits your potential for high returns. Conventional advice is to diversify your investment portfolio; often echoed by financial advisors and brokers.

Let’s start first by answering this question, “Why is diversification a common advice among financial advisers and brokers?”.

An investing legend, Jim Rogers once said: “Diversification is something stock brokers came up with to protect themselves, so they wouldn’t get sued for making bad investment choices for clients. Henry Ford never diversified, Bill Gates didn’t diversify. The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket.”

That’s a bold statement.

But is he right…? Should you not take the advise of financial advisers and brokers?

Financial advisers and brokers provides advise to a broad range of retail investors with different risk profile, most are conservative investors while others are much more adventurous in seeking higher returns. Some investors have no risk-appetite for a 20% draw-down on their portfolios, or the daily volatility of stock prices. Hence a “balanced” recommendation seems to be the easiest and safest route for them. Nothing wrong with that, after all the primary objective will always be capital preservation.

To add on, the level of competency on personal finance and investing varies greatly among retail investors. Most are beginners (although they hate to admit it), who are just seeking alternative avenues to save for rainy days and retirement.

Commitment also plays a role, most retail investors work full time jobs and dedicate very little time to monitor their portfolios. These investors would not have time to update valuations on stocks after its quarterly earnings release or keep up with corporate actions and announcements.

With the rise of robo-advisers and passively managed portfolios, investing becomes alot easier and diversification becomes widely accepted among retail investors.

The Professionals’ Edge

Contrary to that, successful investors operate differently. These investors usually own large and concentrated investments and only focus on their best ideas to generate excess returns. Charlie Munger believes that if you have a portfolio of 50 or more stocks, the losers will cancel out the winners. “This worshiping at the altar of diversification, I think that is really crazy,” he says in a book about his philosophy on investing and life.

Here you can see Warren Buffett (Berkshire Hathaway) and Carl Icahn’s Top 5 holdings.

BRKtop5
Source: Gurufocus.com
CCtop5
Source: Gurufocus.com

 

So why do well known investors like Warren Buffett, Charlie Munger, Carl Icahn, Bill Ackman and George Soros adopt concentrated portfolios?

One word – EXPERTISE.

This means that studying one or two industries in great depth, learning their ins and outs, and using that knowledge to profit on those industries is more lucrative than spreading a portfolio across a broad array of sectors so that gains from certain sectors offset losses from others. Unlike retail investors, professional investors and entrepreneurs are experts in their field which is a by-product of thousands of hours committed to extensive research and knowledge. In Warren Buffett’s words; these investors have developed a circle of competence in their respective fields over years of experience and learning.

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Over decades of their lives, these investors have invested hours every single day learning about business models, industries, economic cycles that puts them ahead of the investing crowd.

Not to mention that they have access to vast amount of resources and talent to help them manage their portfolios.

So if you had invested so much time, effort and resources, why wouldn’t you invest big on your best ideas? Why diversify into meaningless oblivion and dilute away potential returns?

Concentrated investing is about having confidence in your best ideas, it is about self-belief in your work and research done on businesses.

It takes years, if not decades for successful investors to develop such confidence and expertise. If you are an expert in your field, it makes little sense to diversify because you have an edge on the market — that is the average investor and will consequently be able to value a company better than others, leading to larger returns.

Given professional investors have these resources at hand, what is the best option for retail investors? Is it possible for you to consistently generate profits from the stock market?

Well that depends…

Are you a good business analyst? Do you have the ability to look deep into a business to understand its risks and prospects?

If yes, then you have an edge and should concentrate investments into fewer stocks.

However if your answer is no, then I recommend the Walter Schloss approach.

In my previous post here, I wrote about why retail investors should emulate Walter Schloss. He worked with Warren Buffett as a Securities Analyst but never adopted the concentrated investing approach. When asked about Walter, Buffett said:

“Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over again. He owns many stocks than I do – and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.” 

Now, the question is – do we diversify across 100 stocks like Walter Schloss? Is that really necessary? A highly diversified portfolio is more time-consuming to manage because you’ll have more investments to follow. Transaction costs could be higher if maintaining your diversification requires you to micromanage and trade more frequently. That said, what is the optimal number?

In The Intelligent Investor, Graham answers this question, he wrote…

There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.

Graham advised to have anywhere between 10 and 30 companies in your portfolio. As shown in the diagram below, a portfolio of 1-9 stocks is exposed to a wide range of volatility while portfolios of more than 30 stocks marginally reduces volatility. The diagram below illustrates this further.

Diversification
Source: Broyhill Asset Management

Diversification is key to wealth preservation. In the beginning stage of your investing journey, it is crucial to prioritize capital protection first and avoid huge draw-downs in your portfolio.

By doing this, it helps you stay calm and strong psychologically while you learn the ropes of investing. I can assure you that your investing journey is a long road ahead and there will be plenty of mistakes to learn from. You don’t want to pay a huge price for amateur mistakes and give up your investing dream with a psychological scar.

Silton Automotive Co. (1)

A famed trader once said “Novice traders trade 5 to 10 times too big. They are taking 5% to 10% risks on a trade they should be taking 1 to 2 percent risks.” – Bruce Kovner, founder of Caxton Associates.

It’s also possible for diversification to increase your risk if it leads you to purchase investments that are risky or that you don’t understand very well. For example, an investor who lacks exposure to pharmaceutical companies, gold miners, semiconductors, or emerging market economies and knows nothing about these risky fields, might make a mistake by investing in them purely for the sake of diversification.

This is why you should maintain a portfolio of stocks that is manageable (10-30 stocks) and ensure you only invest businesses that you understand.

Over time you will develop your circle of competence and expertise in certain companies and you can make better judgement on investments, that is when you can size up on best ideas and manage a concentrated portfolio.

I hope you are getting the message here – to achieve success in investing, you need a ‘competitive edge’ which is a circle of competence that you’ve developed over time. You need to be committed to learning about investing, businesses and the economy. It will be a never-ending journey. You will constantly learn about the ever-changing business landscape and economy.

While we all dream of consistent market beating returns, it takes time and experience to achieve. One does not become an expert in real estate (for example) overnight, people learn from mistakes and work towards self improvement. Keeping a long term focus and persistence will prevail. Knowledge is a compounding asset…

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