Diversification or concentration? Depends on defining risk
A suitable level of diversification in stock selection will keep a portfolio safe to an extent.
Last month, Berkshire Hathaway Inc. celebrated 50 years since the takeover of the company by Warren Buffett and Charlie Munger. It would be a good time to review some of the differences between the Berkshire way of thinking and that of the academic world.
Munger (vice-chairman of Berkshire Hathaway and Buffett’s partner) once said, “In the US, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations, is securely rich.” Is that right? Can a person be securely rich (or securely middle class) by owning just three stocks?
Many of us would have read that in his early career, Buffett invested 40% of his partnership assets in American Express Co.
The way to wealth of George Soros, too, has been through the use of concentrated bets, and so is the case with a lot of Indian investment gurus. So what about financial planners and academicians who talk about diversification of risk?
Before reaching conclusions, let us look at the arguments for and against diversification. The argument for diversification is simple. If all of your net worth is invested in just one stock and that company were to go bankrupt, you would lose it all. On the other hand, if you had invested in 10 companies equally and one were to go bankrupt, it would affect your net worth by only 10%.
Nassim Taleb, in his book Antifragile, compares this strategy with being hit by a thousand small pebbles over a long period of time versus being hit on the head with a large stone at once. While the former can be a small irritant, the latter may result in death.
The flip side of diversification is that even if you are good at identifying attractive companies, if you put only 1% of your net worth in an attractive opportunity and that investment goes up five times, the contribution to your portfolio returns would be only 4%.
As with most things in life, investors should strive for a golden mean. Extreme concentration may have worked for some gurus but the same gurus do not recommend it as a strategy for the lay investor.
Further, history does not deal in counterfactuals, and we do not know whether the gurus would have been as famous if their concentrated investments had not worked out. For each investor who made it big through concentrated investments, there would be others who made severe losses.
At the same time, extreme diversification only dilutes the returns from the best investment ideas without giving any additional benefit. Hence, the benefit of adding an additional stock to a portfolio when the number of stocks is 50 is not that high compared with the benefit of adding a stock when the number is just five. It has been seen that most of the benefits of diversification are achieved when the number of stocks in a portfolio are 15–20, and after that the portfolio does not get significant benefits from additional diversification. So, then this number of 15-20 may be a golden mean for most investors or portfolios.
In the matter of diversification, lay investors would be better off not following Munger in the strict sense and staying true to the advice of their financial planners.
The other point of contention is the definition of risk. Academia has defined risk in terms of volatility and their favourite measures are greek letters such as beta and sigma. In fact, academics claim that the only way to achieve higher returns is by taking higher risk and that there is nothing like a low-risk, high-return investment.
Buffett and Munger define risk as the risk of permanent loss of capital and exhort investors not to calculate anything that has Greek letters in it. Buffett, in fact, has said that after a big fall (crash) in stock prices, the measures of volatility look elevated while the stocks are less risky since their valuations are more attractive to long-term investors.
This argument is logical and intuitively very appealing. A young investor who is investing for retirement should not look at the daily or monthly volatility as risk. Rather, the true risk for such an investor would be to increase equity allocation at the time of bubbles and to stay away from equities after stock market crashes.
Also, the measures that aim to assess risk are themselves varying. The beta and standard deviation of portfolios are not cast in stone and keep varying even for the same portfolio. Hence, investing on the basis of past statistical measures of risk may not be that great an idea.
While I have read all about betas, sigmas and Sharpe ratios, I still prefer Buffett’s measure of risk as the risk of permanent loss of capital.
A suitable level of diversification in stock selection will keep a portfolio safe to an extent, but this also depends on how an investor views risk.
The original article could be seen here.