Concentration vs. Diversification in Investment Portfolios

For many years, investment managers and academics have argued about the concentration\diversification issue, and although diversification is now widely accepted as the right choice, there are still plenty good examples of concentration successes.

“If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. It’s the ‘LeBron James’ analogy. If you have basketball phenom LeBron James on your team, don’t take him out of the game just to make room for someone else.”

– Warren Buffett

Buffet is the perfect example of the concentration strategy working perfectly. If you study in detail Buffet’s methods in the early stages of his career, you will notice that he has concentrated his investments each time he perceived a great opportunity. Often, Buffet would load the bazooka and shoot! This was how he ended up owning Berkshire Hathaway, a decadent textile company, in the 60’s. I even dare to say that some of his early moves could have ended badly. His early investment fund could have been vanished if the agricultural machinery company that he ended up owning (because he wanted to unload the pile of bonds that they owned) had gone out of business (as for a long time it seemed that it would be the case).

Incredibly or not, he was able to turn around that company and ended up richer than before, but during his adventures in the late 50’s he made some risky concentrated bets. After this, Buffet entered a new phase in his career: Inspired by Charlie Munger, he started to notice that quality for a fair price is better than a great price for a mediocre asset. However he kept the concentration tendency. The GEICO business is one of those examples, he saw a growing stock badly priced, since he had the cash-flow from the textiles operations, he went all-in.

The American Express business was similar, he saw a scandal throwing down the stock price of AmEx, he calculated that the company was in the same position than before, and in one year no one would remember the scandal, so here goes the bazooka! The same goes for Coca-Cola, Washington-Post, etc…

I truly appreciate Buffet’s strategies in the late 60’s and thereon, but some of his moves in the early years were really risky. However, I do not think that they were risky because of concentration. I even believe that concentration allowed him to work out better the problems that arose from the low quality of the businesses he entered. He was so concentrated in a handful of companies that he had the time to focus his effort in sorting those problems. Imagine if he had another 40 stocks to pay attention to…

So my take on this is very simple: the small investor should not refrain from doing some diversification, but at the same time he does not need to have more than 10 to 20 stocks, more than this is just attracting troubles. If a small investor has 50% percent in secure bonds, and the other 50% equally distributed in 10 stocks, he will not have more than 5% in each stock, which is pretty conservative and at the same time, it is a good diversification.

Now for the pundits who will say that Buffet now owns more than 80 businesses, I will say that he does so because he also has more money to invest than in any point in the past. He made most of the opportunities that he had, and I bet he would like to own more Coca-Cola, or Wells Fargo stock, but unfortunately he isn’t the only investor in the market and obviously at some point he couldn’t buy more significant portions of those stocks and had to search alternatives to his LeBron James. On the other hand, Warren does not buy significant portions in many new investments at the same time, usually he buys one or two businesses and focus in accompanying them, observing their performance and intervening if he thinks that things are starting to go astray (which is not very often).

In the end, I believe that investors should not exceed the 20 securities limit. Obviously, if you are an investment manager at some fund, your fund will own more than 200 securities, but what I am saying is that each manager should be focused in accompanying 10 to 20 different securities, in order to be able to deal with all the information and to react promptly.

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