Tuesday, July 7, 2015

Portfolio Diversification: What's the Right Amount?

Portfolio diversification, something I briefly covered toward the end of this recent post, is an investment topic that necessarily leads to a wide array of opinions.

At the 2014 Daily Journal (DJCO) shareholder meeting, Charlie Munger explained that his investments are primarily invested in Berkshire Hathaway (BRKa), Costco (COST), and one other fund. He then added:*

Now, you could go to the rest of finance, they think they know how to handle money, and they'd say it's totally unthinkable, Munger doesn't know what the hell he's doing. Doesn't fit our models. But I'm right and they're wrong.

If you're shrewd enough to choose well, three holdings – any one of which would support your family in perpetuity — is enough security.

and

The people who make these crazy decisions don't actually have envy: what they have is clients who will fire them if they don't get the same results as everybody else. That is a crazy system. Everybody gets on the same merry-go-round.

Munger has offered a similar view on prior occasions and there's, to say the least, much to be learned from it. Yet, while this certainly makes sense for someone with his investing background and abilities, it hardly means such a concentrated portfolio is a brilliant way to go for everyone. The appropriate amount of diversification will be specific to an investor's capabilities and situation.

It'd likely prove a big mistake to think otherwise.

Consider that Munger also once said:

"Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund."

The question of whether it makes sense to own individual stocks at all first needs to be answered. After that question is answered, those who do decide they're comfortable picking stocks may, unlike Charlie Munger, still prefer to own more than just a few.
(Though it's generally unwise to be risking funds on a 50th best idea when those funds could, instead, be put into a top idea.)

So it's very much an individualized decision, and that decision must always be made in the context of the price environment.

More from the Daily Journal meeting:

...the consultants and investment bankers keep selling the same nostrum that you can save yourself by paying thirty times earnings for the kind of business you wish you had, instead of the one you've got.

It wasn't all that difficult to find stocks selling for huge discounts to intrinsic value four to six years ago or so.

That's far from the case now.

When shares get cheap enough (i.e. price nicely lower than intrinsic value per share offering substantial margin of safety) it's easier to accumulate lots of what you like.

In contrast, a concentrated portfolio of stocks bought at premium prices is, in the long run, just asking for trouble. Consistent correctness in such a situation is whole lot easier in theory than in the real world.

It's worth noting what initially appears to be a premium valuation at times proves to be otherwise. Sometimes, what's richly valued turns out to be worth it and then some. Figuring this out, in a reliable way, beforehand without making big mistakes and incurring big losses that mostly offset other gains -- or, maybe, more than offset other gains -- is, of course, the tough part.

In other words, the range of outcomes quickly become unacceptably wide and there's too much downside if things don't go as expected.

The avoidance of permanent capital loss is paramount. Well, paying a big premium for a stock with the hope that optimistic assumptions about the future come to fruition isn't really compatible with portfolio concentration.

The same goes for investor overconfidence.

Overconfidence combined with a concentrated portfolio -- or, for that matter, any portfolio -- is an investment disaster in the making.

A healthy dose of doubt and careful consideration of possible misjudgments can serve the investor well.

The price paid should always protect against disappointments and mistakes.

Munger was asked later at the same meeting what he viewed as the right number of companies in a portfolio. His answer was simple:

I don't think there's any one answer to that.

The right number of stocks to own is necessarily not one size fits all.

The fact is many over the long run will end up better off investing in low-cost index funds -- and this doesn't just apply to inexperienced individual investors, it also can apply to, in enough cases to matter, very able and experienced market participants** -- while avoiding leverage, the temptation to trade excessively, and needless frictional costs.

That's difficult enough to do well if for no other reason that fear, greed, and other behavioral factors come into play in a way that too often leads to inopportune buy/sell decisions and, ultimately, adverse investing outcomes.

Some will focus on the analytical challenge that's in front of them but underestimate the temperamental/emotional discipline that's required.

Buffett, also one who generally prefers portfolio concentration when possible, said the following in his most recent letter:

"Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."

Essentially, in Buffett's own investing approach, he has a preference for less diversification, but is well aware that "inadequate diversification" can get an investor in trouble. From the 1993 letter:

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, 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."

A very concentrated equity portfolio works just fine for some.

A diversified low-cost index fund -- accumulated over time but otherwise traded minimally -- works just fine for many.***

Portfolio concentration can work under the right circumstances but it's hardly for everyone.

Figuring out the "right circumstances" requires -- among many other things -- careful consideration of one's own temperament, aptitude, limitations, and resources.

Those who choose to concentrate their portfolio without the requisite proficiency are likely to make substantial and costly mistakes.

Deciding on the appropriate amount of diversification isn't always easy to figure out.

It's best to act accordingly and give it the careful consideration it deserves.

Adam

Long position in BRKb established at much lower than recent market prices; no position in other stocks mentioned.

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Some seem willing to believe otherwise despite evidence that refutes it. Naturally, there are some very capable investors with excellent track records but a whole bunch simply can't match their relevant benchmark index over the long haul.
*** Not necessarily a single fund. Some will consider multiple funds to be more appropriate.
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