A good friend of mine and I were discussing about…
Many people assume diversification is good because it minimizes risks when one of your investments do not turn out to be expected. This is logical, but in general you much rather have a few good selections than many selections. Just before I begin though, I do want to give credit to Warren Buffett for raising and explaining this concept of concentration. Whether or not you’ve read his essays on his stance on diversification, I urge you to continue reading this post to learn more about when concentration or even diversification makes more sense.
Let’s start off explaining why concentration is in general a much better strategy. First, it gives you time to analyze each company. Companies constantly have news and earnings report. Their industries are constantly undergoing changes. The economy is constantly spewing out economic data. To sum it up, you do not have time to analyze, let alone understand, everything! Especially if you aren’t working at a field related to investments, the time dedicated for investing activity may be very limited. You want to invest in as many companies as you can keep up with in digesting their information and making sense of it. You also want to invest only as much as you can keep yourself sane; imagine thinking about 100+ stocks every night when you sleep, that’s going to drive you crazy! And it’s important that when you research your companies, that the research and analysis of the company is done thoroughly and adequately. The higher quality of work you do, the more accurate your valuation of the company is. If you have 100+ stocks and you’ve only glanced at their balance sheets for 10 seconds, how could you determine when it’s undervalued or overvalued? When do you buy or sell the stock? What ends up happening is that it becomes a guessing game! In the latter case, you may as well pay a management fee for a professional fund manager to handle that many stocks – at least they have a team to do the work for you, and you have someone else to blame other than yourself if you lose money right? 🙂
Speaking of being thorough, I believe that the more homework you do for a stock well worth investing, the more you should concentrate your capital on those stocks. Think about it – let’s say you’ve analyzed company ‘Feet Enjoyment’, a fictional shoe company, and you expect the business valuation to be worth at least $6 per share, it’s currently trading at $3, and if the worst case scenario that you’ve predicted occurs, it drops down to $2.5. Your risk reward ratio is 6:1 here, this is a fantastic opportunity! What I don’t understand is that these investors, who’ve done the work, decide to invest in other shoe companies without even knowing their prospects or valuation; they are just making a blind bet. There are two scenarios which I can think of right now that make people behave irrationally:
1. You didn’t do your homework thoroughly enough or you are not competent enough to do a high quality analysis. In this situation, you are correct in doubting yourself. To solve the former problem, it’s so simple – do the homework thoroughly! For the latter, you keep doing it and you will eventually become better. Go and observe other people’s analysis and see how they do the math. I used to (and I should still be doing although I’ve slacked off) visit this website called Value Investors’ Club since value investing made the most sense for me. As a guest, the posts shown may be a couple months delayed; it doesn’t matter – what you want to do is to learn how people valuate companies.
2. All the so called “professionals” in the world are brainwashing you on the concept of diversification (and they too are very much likely brainwashed themselves), and then you believe it and you choose equities that may not give the same risk / reward ratio. Your analysis was very well though. In this scenario, you need to be confident in yourself! Given that the maths were done right, the next thing you need to conquer is maintaining your confidence. You should not doubt yourself in these situations.
But here’s a key question – no matter how much ‘analysis’ you can do, there will always be uncertainties. One day the company is charged for bribery or money laundering. Or maybe the industry suddenly faces a permanent shortage of demand, or the country faces a financial crisis. First thing you need to tell yourself is that you’ve done the best you could and you can’t blame yourself for these unforeseeable scenarios. Second thing is that you need to ask yourself if the problem the company facing is temporary or permanent; in a temporary case where the company’s businesses are still going strong, you actually want to buy more shares if the price drops – the reward/risk ratio just became more attractive. When the problem is a permanent one, most people panic and make the wrong decisions by hoping to ride it out or even buying more shares, when the correct move is to admit that you’ve overlooked an aspect and cut your losses.
I think people diversify because they fall into this logical fallacy that if something really bad happens to the company, let’s say bankruptcy, they will lose all the capital invested in one day. Rome wasn’t built in a day, it also didn’t fall in a day either. Sure, the company’s shares will be declining rapidly, but it does not mean that you do not have time to get out before you lose everything. This is another reason why it’s so important to focus on only a select few stocks – you need to be consistently be aware of when to cut losses if something significantly bad happens to your investments, and you need to act quick. Those who ‘hope for the best’ end up with the worst.
So when exactly should you diversify? Good question. The less thorough or effort you put into your homework, the less knowledge you have, the wider your diversification should be. If you have knowledge that China will do well in the next 10 years, you want your capital in China, but if you have absolutely no clue to which country will do well, you spread your risks and hope for the best. Or you believe the finance sector will do well, you put a good portion of capital in the finance sector. But if you have absolutely no clue, you again spread your capital amongst the industries. Because you are clueless, if you put your eggs in one basket and you end up choosing the wrong basket, it can be a disaster for you, so basket picking becomes a lucky guess. A concentration strategy only works when you’ve analyzed that the basket is safe. So yes, a little homework does go a long way.
In situations where you lack knowledge though, it’s much better to have a fund manager to take care of your capital than trying to make lucky guesses. Let’s say you believe China will do well and that the issue of shadow banking is overrated, but other than that you are absolutely clueless on what to invest in China. In this case, you should choose a fund manager specializing in China who shares your investing philosophy. Or you can just invest in index funds or ETFs. Alternatively, you can abstain from investing.
Another situation where diversification is a good strategy is when time is limited but an industry (or maybe even a country) faces a temporary setback that has caused the industry stock prices to plunge. A perfect example (albeit with a sad story) is the 9/11 incident when the terrorist attacks caused airline prices to free fall 50%. First, we know the airline industry is still going to exist even after the attacks – there simply isn’t an alternative transportation other than flying to get to faraway places at an efficient manner. Secondly, we want to choose airlines that appear to have strong balance sheets and are more dominant in the industry; weaker airline companies will invite much more doubts about safety since cheaper products / services are usually associated with cheaper quality in a consumers’ mind. Third, you want to choose airlines with good liquidity. Let’s say you’ve identified 20 such stocks. Then with the amount of capital you wish to invest in this sector, you equally divide the capital between the 20 such companies and wait for the panic to disappear, waiting until the airline stocks rise to its proper valuation. (By the way I forgot which book / investor claimed he equally spread his capital buying airline stocks after the 9/11 incident so if anyone knows which investor or book I’m talking about please e-mail me or comment below!!!).
To sum up this post, here are the the few suggestions I’ve listed today: Invest in as many stocks as you can keep track of; the more you analyze a company the more concentrated your portfolio should be (but of course don’t just put all your money in one or two companies!); consider abstaining from investing or investing in an index fund or choosing a fund manager for your capital if you are clueless with investing; and an exception to diversify is when an industry faces a temporary setback.
Do you have other reasons to support my concentration or diversification theories? What about reasons that go against it? Comment below.