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When Warren Didn't Listen to Harry

September 11, 2007
10qk

Krasimir Karamfilov

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In 1952, Harry Markowitz wrote an essay, entitled “Portfolio Selection".

In 1959, he wrote a book, entitled “Portfolio Selection: Efficient Diversification”.

In both writings, he laid out the diversification theory, which, Harry thought, helps to offset the uncertainty and risk of investing in the stock market.

In 1990, Harry won the Nobel Prize in Economics. He is considered the Father of Diversification.

Good for Harry.

Now, let’s continue with the definition of the verb diversify:

1. To make diverse: give variety to
2. To balance (as an investment portfolio) defensively by dividing funds among securities of different industries or of different classes
3. To increase the variety of the products of

As you can see, one of the definitions is related to money. That’s a good start.

What do they mean by “to balance an investment portfolio among different classes”?

In order to invest your money in different asset classes, you must know what asset classes are out there:

  • Stocks (equities)
  • Bonds (fixed-income)
  • Precious metals
  • Real estate
  • Cash and cash equivalents

There are many schools of thought as to what percentage of your saved money goes to each class.

In my experience, it all depends on your life situation. If you live lavishly, you probably need more cash.

If you are a penny pincher like me, you have little cash and more equities.

A well-balanced allocation of, say, $1,000, goes like this:

  • Stocks: $500 (50%)
  • Bonds: $250 (25%)
  • Real estate: $100 (10%)
  • Cash: $100 (10%)
  • Precious metals: $50 (5%)

Millions of people around the world diversify.

Millions of people have their money in 401(k) plans, which are diversified.

Millions of people retire, thinking that they increased their wealth in the last 30 years of work.

Here’s what I have to say to these people:

STOP THIS MADNESS!

Diversifying is like shooting yourself in the foot: You’re not dead, but you bleed money all the way to the grave.

WEALTH TRUTH #1: Nobody in the history of the world has ever become wealthy by diversifying.

To paraphrase: You will never be wealthy if you diversify.

Let me give you a couple of examples on why you shouldn’t diversify.

Had Bill Gates diversified, he would have sold half of his Microsoft shares and invested the money in… something.

Does he do that? No. Would he be the richest man on the planet if he diversified? No.

Does Warren Buffett diversify in bonds and gold? Of course not. He has 99% of his net worth invested in Berkshire Hathaway stock.

Why don’t the top two richest men in the world diversify?

WEALTH TRUTH #2: Concentration of capital builds wealth.

Therefore…

WEALTH TRUTH #3: Diversification of capital destroys wealth.

So, here’s my sage advice:

When you decide to invest in a particular asset class, invest ONLY in it.

In other words, don’t dabble in real estate, if most of your money is in bonds. Don’t buy gold, if you hoard your cash.

This way, you know where you’re headed. If you diversify, the volatile economy will kill your investing efforts.

Naturally, I am partial to investing in stocks. Nothing has beaten, beats, or will ever beat the investment returns from investing in stocks.

But we are all different. Who you are as a person will determine your investment strategy, risk tolerance, and profits.

We all work so one day we won’t have to work. The only way to succeed in this effort is to invest our money and get the biggest possible return.

Diversification is a guaranteed way to get lame returns. You can’t get more than 10% annual return with diversification.

Should that be your situation, I have news for you: You’re wasting your time. Here’s why:

- Inflation will eat up 3% of your profits

- Your rampant spending habits will take another 2%

- Life emergencies will use 1%

If you save $5,000 per year at 4%, after 30 years of work you’ll have $291,641.

With this much saved, you’re looking at 6 years of retirement. Then what?

Sadly, Harry Markowitz’s diversification theory was embraced by the masses. Warren Buffett’s trumpeting of the value investing theory was not.

I’m glad Warren did not listen to Harry. If he had listened, we all would have been much poorer for it.

________
By Krasimir Karamfilov, who is the manager of Pirgos Mirgos LLC, an investment company in Santa Monica, CA. He holds two Master's degrees in the arts, which helps him invest creatively.

About the author:

Krasimir Karamfilov
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.0/5 (24 votes)

Comments

billytickets
Billytickets - 6 years ago
Krasimir you can email me at ticketbill@aol.com anytime. I gave you 5 stars because your article was DEAD ON. Each person needs to INVEST in a stock or STOCKS that suit them best. I had 1 position for along time.Now I have gotten "reckless" and have 5 BIG positions. I am all for COMMON stocks that meet my"strict parameters" and if u only own 2 or 15 the key is price is what you pay Value is what you GET
yhlbb
Yhlbb - 6 years ago
"WEALTH TRUTH #1: Nobody in the history of the world has ever become wealthy by diversifying."

This is simply a false statement.

Gates and Buffett are super-rich for a reason, and the reason is *not* that the don't diversify.


vooch
Vooch - 6 years ago
This article is ridiculous. It's telling me to buy stocks and not own a home. Wrong!

Read Peter Lynch. He says, buy a frickin' home first, then start buying stocks.

- Vooch

vooch
Vooch - 6 years ago
ravinsu,

Never assume.

- Vooch

sarpotd
Sarpotd - 6 years ago
This is oversimplifying diversification by giving false examples. Bill gates getting rich can be easily explained as statistical anomaly (a sample at the extremes). Your article would be far more believable if you proved that MOST people that dont diversify end up doing better than MOST people that do.

Finally diversification is about reducing risk not about increasing return. If diversification helps reduce volatility in your portfolio and helps you sleep better then its worth purusing. I do realize that reducing volatility in the short term and increasing returns in the long term may not be correlated and sometimes are mutually exclusive (like holding just cash)
singapura
Singapura - 6 years ago
What I miss in the whole article is "did anyone become poor because of not diversifying?". The answer is obvious. Spreading your risk makes you less prone to market volatility. Warren Buffet didn't get rich because he invested for 99% in Berkshire Hathaway. When he started investing the fund didn't even exist. Gates became rich because his company captured a lucrative market not because he invested. Did the people that invested only in Enron become rich? How about the investors of Worldcom?
billytickets
Billytickets - 6 years ago
Fellas I don't think you understand what the author is TRYING to say.

For 9 years years i put my money into 1 stock Altria. EVERYONE told me that it was too risky and even though my last purchases were at a PE of 8 and a dividend yield of 9.9% they told me I was wrong. In the past year 100's of people( the vast majority who i would bet have not made as much as me investing in their lifetimes) including many on this forum who I respect have told me to sell off some MO and"diversify"

Fact is the true value investor like WEB has made the LIONS SHARE of his profits on less than 10-12 investments over a 42 year span. He"hammered" WASh Post in the 1973, See's candiesand the Buffalo News in 70s Coke in 1988 WFC and AM EX in the 90s Gillette in the late80s early 90s and JNJ BNI BUD IScar in the 2000's.

A stock like JNJ is being"given away" according to WEB Evellard and others but how many peopel here put60-75% of their avialable cash in investing for JNJ.Read Charlie Mungers speech at USC 1994( Google search it) WEB has spent the last 50 Yeras BETTING BIG when he LOVES something

Vooch i believe the author meant not to"dabble" in other investments and i do NOT believe that diversification "itself" is a problem LIKE THE AUTHOR DOES but DIVERSIFICATION is NO PROTECTION AGAINST THE INHERIENT RISK of buying stocks EITHER.There are 2 "risks" when you buy a stock 1) The future earnings of the business itself 2) The Time Frame selected

I personally follow the "punch card rule" and am shocked at the types of companies that the "majority" of posters on here "speculate" on. EACH person has to adopt their own style but INVESTING EVERYTHING each year in the 1 stock you LIKE THE MOST will be OPTIMIAL if you are a GREAT INVESTOR. If that is the same company for 9 years like it was for me In Altria from 1993-2002 IaM LIVING PROOF that you can DO WELL>peace

roke6362
Roke6362 - 6 years ago
The 2 most important things I learned in grad school:

1. Cash is king. When you have cash, you have options.

2. Know what business you are in, and never forget it. Stick to your knitting, so to speak.

I realize WEB has 99% of his net worth in BRK. However, in the 40+ years he has owned BRK, what type of acquisitions has he made? Have they all been in the same type of industry? I would say he diversifies. WEB is an investor/capital allocator. That is his business! Within that parameter, he spreads his risk.

The people who lost their fortunes in Enron or Worldcom were not investors. Otherwise they would not have been so heavily in those positions.

I am a small businessman. I am not publicly-traded. Therefore, my business is worthless unless someone wants to pay for it. Or, I can take the free cash flow it generates and invest it elsewhere. That, by definition, is diversification. I own real estate, but am not a landlord (except to my company). I own stocks as well, but I am not an full-blown investor.

I am an insurance broker whose main asset is intangible. By diversifying, I am creating something tangible from something that is not.

Therefore, I think it depends on the situation. It also depends on timing. I believe WEB and Gates caught lightning in a bottle. I don't think either one of them could start from scratch and have the same kind of success. Would they be successful again--absolutely. Just not to the same degree. Once most great fortunes are made, it has been shown that it is better for most fortunes to be re-invested in an index fund than to keep plowing it back into the business that generated the fortune in the first place. I'm sure there are exceptions, but I believe this to be the rule.

Dregw
Dregw - 6 years ago
I have to agree with both sides here, but if you know a cheap blue chip stock when you see one, I think you load up like there's no tomorrow. Speculating is for gamblers, investing is for getting rich. I like Billy's book because it gives a formula with a big margin of safety and should really only be applied to blue chips. I would be highly surprised if a stock that "qualifies" right now like JNJ doesn't give spectaculor returns when we look back in 5 years.
Krasimir
Krasimir - 6 years ago
Friends,

The bottom line of my article is this: Do not spread yourselves too thin. Do not own 30, or 100 stocks. Do not waste your capital for bonds, when you know that stocks will give you higher returns in the long run.

As per the real estate issues, the truth is this: real estate, either buying it built or building it, is a hard business with average returns. You lock your capital in a building and lose the compounding. Very few of us have the time to flip properties every two years. So forget about it and stick to stocks.

Finally, when you read something, even if it's Peter Lynch (whom I like a lot), or the bible of bibles, please question it. Don't follow it blindly.

I gave the extreme examples of Bill Gates and WEB for clarity, not to categorize the most intelligent investing model out there. I'm sure that you will find your own investing models that will work best for you.

Happy investing,

Krasimir
armeetofo
Armeetofo - 6 years ago
true, stick with what you believe and comfortable ones.
billytickets
Billytickets - 6 years ago
well put armee .Reread my article to support his article http://www.gurufocus.com/news.php?id=8754
armeetofo
Armeetofo - 6 years ago
thanks, i dowloaded it in my computer and reread it many times, very useful, thanks a lot.

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