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Investing framework: Concentration vs diversification - Views on News from Equitymaster
 
 
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  • May 26, 2008

    Investing framework: Concentration vs diversification

    In the previous article, we discussed the importance of 'preparation' in building an investing framework. In this article, we shall address the question of concentration vs. diversification at each stage of the investment process.

  • Earlier articles in the series

    Concentration vs. Diversification
    The role of diversification in constructing a portfolio is a hotly debated topic in the world of investments. While many investors who pick stocks based on a qualitative study of the business (growth stocks) prefer a concentrated portfolio, many academics (market-portfolio and beta) and practitioners (index funds) advocate extreme portfolio diversification. Although 'concentration vs. diversification' is usually discussed in the context of portfolio construction, it is equally applicable to every stage of the investment process.

    The investment process can be divided into three stages- generating investment alternatives, eliminating the alternatives and finally selecting/ constructing a portfolio. Let us begin at starting point.

    Stage 1: Generating investment alternatives- Diversify
    It is wise to be open to a wide variety of investment ideas when one is generating investment alternatives. No economy, sector, company or instrument should be outside one's investment radar. As Charlie Munger mentioned in the 2007 AGM of Berkshire Hathaway, "I don't think there's any substitute for thinking about a whole lot of investment options and thinking about the returns from each."

    It may be noted that while Warren Buffett is generally known as a long-term buyer of equities, he is open to all types of investment alternatives. In 1997, for example, he held derivative contracts for 14 m barrels of oil. In the same year, he purchased 111 m ounces of silver. He also made a macro-based commitment that year in long term zero-coupon bonds. He has also held junk bonds, and convertibles. He has also dabbled in short term event based arbitrage such as company mergers, reorganization etc. As Warren Buffett mentioned in the 2007 AGM of Berkshire Hathaway, "You can have a reservoir of thinking, looking at markets in different places, different securities, etc. The key is that we knew what we didn't know. We just kept looking. We knew during the Long Term Capital Management crisis that there would be a lot of opportunities, so we just had to read and think eight to ten hours a day. We needed a reservoir of experience. We won't spot every one, though -we've missed all kinds of things."

    Even within common stocks, Buffett started his career looking for average companies at attractive prices and switched to attractive companies at reasonable prices during the later part of his career when Berkshire's corpus became too large for small bets.

    In fact, generation of alternatives is so important that when Buffett was asked on Money World, (PBS, 1993) what investment advice he would give a money manager just starting out, he said. "I'd tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities." Moderator Adam Smith protested, "But there's 27,000 public companies." "Well," said Buffett, "start with the A's."

    Stage 2: Eliminating the alternatives - Concentrate
    After looking for investment alternatives at all possible places, one should then discard those that are too hard or fall outside one's circle of competence. As Warren Buffett mentioned in his 2006 talk at the University of Kansas, "First, you need two piles. You have to segregate businesses you can understand and reasonably predict from the ones you don't understand and can't reasonably predict. An example is chewing gum versus software. You also have to recognize what you can and cannot know. Put everything you can't understand or that is difficult to predict in one pile. That is the too hard pile. Once you know the other pile, then its important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs (annual reports), etc. Read about the competitors."

    Stage 3: Constructing a portfolio- Concentrate / Diversify
    Unfortunately a nuanced understanding is never offered on the question of 'to concentrate or to diversify a portfolio?' and as a result a lot of fixed (and inaccurate) ideas float around. The correct answer is 'it depends on the investment idea'.

    One category of investment ideas is a reasonably priced stock in a high quality business. For these, Warren Buffett says in his 1993 letter to Berkshire shareholders, "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. In the words of the prophet Mae West: 'Too much of a good thing can be wonderful.' "

    However, for other categories of investment ideas, he continues, "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."

    However all investment ideas, no matter which category they fall into, must pass the test of 'margin of safety' to be included in a portfolio. It is the ultimate safety net against losses arising out of bad ideas.

  • Margin of safety

    We shall continue with our discussion on building an investing framework in the next article.

    Reading is an excellent way to develop one's investment framework. We urge you to refer to investment classics (books, articles and speeches) in the original.

     

     

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