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Post updated 8/11/2020 to include Bobby Kraft interview with Maj Soueidan discussing this subject matter on the SNN Network
Diversification vs. Concentration
Social media allows anybody to try and portray him or herself as an expert. If you’ve come to trust such sources, you may even get to the point where you may view the content as gospel
Unfortunately, more often than not, some of the information we are fed is under-researched and well, just false. Furthermore, the number of twitter followers does not necessarily make a person an expert. Occasionally, I am guilty of making quick affirming judgements based on tweets I read, retweeting them and then feeling like burying my head in the sand near my Fort Lauderdale home, when I realize that the tweet was misrepresenting a broader point.
For example, there’s plenty of banter on Twitter stating that concentrated investing is much more optimal as a strategy than diversified investing. Just like in the short selling arena, there is a “cowboy coolness’ that can be attributed to concentrated investing.
Quotes from the likes of proven investor Warren Buffett adds to the concentrated investor montra casually repurposed by some investors.
“In fact, if you are doing your research, according to Warren Buffett there’s no need for diversification at all. At the 1996 Berkshire Hathaway annual meeting of shareholders, Buffett declared that diversification is a “protection against ignorance.”
“that is sure to result in mediocre returns, returns that are less than the market itself because of your fund manager’s fees. Mr. Buffett believes emphatically that the only way to consistently outperform the broad market is to focus one’s money on a few really good companies that are on sale.”
To be frank, I am not a huge Buffett fan, although I do love his sarcasm and believe that so many of his quotes are on point. However, I took particular exception to his “protection against ignorance” quote. This is quite frankly because I don’t agree with every aspect of his strategy and some of the ways that I invest can stand in contrast to his most widely used approach. Having said that, there are times when I think concentration is useful. More on that later.
I am more of a Peter Lynch fan who I find to be more relatable to the everyday investor. He proved that one could beat the market with a diversified portfolio. Lynch owned hundreds of stocks while taking the fund from $18 million under management to $14 billion managing the Magellan Fund between 1977 and 1992. In fact:
“Magellan had about 60 stocks when Lynch took over, and he was advised to trim that number to 25-30. He instead bought hundreds of stocks he believed were bargains, including the then-unusual step of owning multiple stocks from the same industry. In 1989, Magellan held an unheard-of 1,400 stocks.”
Oh by the way, the fund averaged 29.2% during Lynch’s tenure. So, this clearly runs contrary to Buffett’s stance on diversification. Or does it ? Well, yes and no.
This tweet by mircoap investor, Ed Gilmore, who I recommend every investor should follow on twitter @ELG, sheds some additional light on Buffett’s opinion on diversification:
After watching the video it is apparent that Buffett is a big believer in extreme diversification in some cases.
“If you are not a professional investor…if your goal is not to manage money in such a way so you get a significantly better return than the world, then I believe in extreme diversification”
He goes on to say that…
“maybe more than 99% of people who invest should extensively diversify”
Buffett is probably right to conclude that most non-professional investors can’t beat the market and that they should practice extreme diversification (essentially becoming the market). Case in point: When Peter Lynch ran a study to determine the average annual return that retail investors achieved while he managed the Magellan fund, he found that they averaged just 5%! Basically, the everyday investors were adding money to the fund when the market was doing well and redeeming money when the market was going down.
What Buffett is essentially preaching is that most investors should just invest in index funds and be happy with getting market returns. And he is probably right, so maybe I should not have been so hard on Buffett.
However, I am still somewhat at odds with Buffett on his belief that diversification is the only strategy that professional investors should follow:
“once you are in the business of evaluating businesses and you decide that you’re going to bring the effort and intensity and time involved to get that job done then I think that diversification is a terrible mistake at any degree”
He goes on to say that :
“I mean if you could identify six wonderful businesses, that is all the diversification you need and you can make a lot of money, and I will guarantee you that going into a seventh, rather than putting more money in your first one…it’s got to be a terrible mistake. Very few people have gotten rich on their seventh best idea. Now, a lot of people got rich on their best idea.”
Buffett’s position fails to take into account that he is a very special investor that allows him to be a very concentrated investor, in the same way that Lynch has unique characteristics that allowed him to excel through extreme diversification. You may have the emotional makeup where you need diversification to sleep at night, but that does not mean you can’t beat the market. And what about those investors who got poor betting on only a few horses?
To be clear, Lynch did warn about the everyday investor over diversifying and that you only needed a few good stocks in a lifetime to do really well. However, Lynch is proof that one can beat the market by a wide margin being extremely diversified. Personally, I have consistently beat the market by at times being extremely diversified (around 400 stocks at one point in my career) and at other times being highly concentrated, like I currently am.
This discussion goes back to some important points I always come back to. There is no one way to invest. In order to find success as an investor you have to find strategies that you connect with and then become really good at it. Furthermore, your strategies can change over time depending on your experience and market environment. For example, I have been an extremely concentrated investor over the past 10 years compared to extremely diversified during the first 20 years of my full-time investing journey.
Now, if you were to put a gun to my head and ask what I think is the most optimal investing strategy when it comes to diversification vs. concentration I would say that creating a long-term core portfolio of 5 to 12 stocks, combined with a strategy of placing shorter term bets on special situations or growth inflection scenarios is the way to go. Beginner investors might want to consider being on the higher end of diversification and become more concentrated once more experience is gained.
Anyways, have a great investing week!
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