Thursday, December 4, 2008

Concentration vs diversification

The argument between whether to concentrate investments or diversify is sometimes taken to extreme as if one or the other is the correct way and that it is always true.

Lets look at what Mr. Buffet has said. Warren has outlined two different strategies based on the type of investor. Warren has said that in cases where an investor can bring intensity to the game("know something investor"), concentration would be beneficial. In cases where the investor wants to participate in stock market returns but is either not interested or not trained ("know nothing investor"), it is best to buy an index fund that broadly gets market return. Do not automatically assume that smart money will outsmart dumb money. Warren adds that when dumb money acknowledges it's limitation (and invests in index fund), it will in many instances outsmart the "smart" investor. Beating the market is no easy task over long periods of time in any significant margin.

To me, both these make sense. So what do I do. For my retirement accounts(401K, IRA), I pick mutual funds. On my personal account, I pick stocks and this is usually focussed on 10 to 15 companies bought over a period of 2 to 3 years. These are well run businesses that produce cash and have decent growth prospects and are not highly priced. I do my own investing because I like to study, learn and understand investing in good businesses. I will not consider studying a business waste of time even if I decide to not invest in it. So as long as I enjoy investing, this dual strategy works well for me. This mixed strategy gives me the best compromise. If I mess up my personal accounts, the retirement accounts will at least be safe. If I do well, it will produce a meaningful return.

I think there is another piece of treasure I heard from Bill Miller interview that is meaningful for this downturn. This advice adds another dimension which is market pricing. When the market is selectively cheap (one company or a group of companies), it is meaningful to concentrate on those few investments. However, if the market is cheap across the board, then excessive concentration is not necessarily a smart strategy. When market recovers, most stocks will have decent upside. So in this case, some diversification is called for because this will produce returns similar to concentration but at the same time limiting certain stock specific risk.

During this downturn, I feel Bill Miller's strategy is applicable. I have purchased companies that are new to portfolio. In addition, I have also reshuffled some within my portfolio for tax reasons.

Bottom line play the game only if you are both interested to spend time as well as have the necessary aptitude. Even then, do not feel compelled that you need to do choose one or the other. Do what works best for you. Note Berkshire Hathaway itself is highly diversifed and it has moved in that direction from day one though not necessarily for this reason alone.