In Berkshire's 1993 letter to shareholders, Warren Buffet discusses diversification eloquently, "The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."
Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy. Of course, some investment strategies - for instance, our efforts in arbitrage over the years - require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment - one that indeed has a significant possibility of causing loss or injury - if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.
Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.
Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, 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. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.'" 1
Either an enterprising investor can select investments that provide returns superior to the market or he cannot. If the latter is true, then surely a broad-market low-cost index fund is the most suitable investment. However, if he can, then it follows that all potential investments are not equal, and it seems unreasonable to treat them so. The weight of any one investment in a portfolio should be determined by the confidence and size of its return, with an appropriate margin of safety for error.
We aspire to hold a few dozen superior positions rather than a hundred average ones. We strongly believe that casual investing increases risk rather than reducing it, and if we do not have the confidence to place a significant portion of our portfolio in an investment, we must reconsider whether to make it at all. That is not to say that all investments will be of any particular size, and it does not disregard the common sense not to put all one's eggs in one basket. We hold to the principle that anything worth doing is worth doing well.
© Daniel Dower (2011)