An interesting topic of debate about investing is diversification and how much diversification every investor should include in their portfolios.
Generally speaking, some of the world's best and most prominent investors, such as Warren Buffett (Trades, Portfolio), Charlie Munger (Trades, Portfolio) and Carl Icahn (Trades, Portfolio), advocate using concentrated portfolios to generate the best returns. And if we look back at the list of the wealthiest people of all time, and how they got to that stage, it quickly becomes apparent that by having one substantial investment there is a higher percentage chance of you making an obscene amount of money (the list of the world's wealthiest people today shows this trend in full force).
There is one significant caveat to the strategy of using a highly concentrated investment portfolio. This caveat is that you have to be willing and able to conduct rigorous due diligence on every opportunity presented. If you don't, investing all of your money into one opportunity is a shortcut to bankruptcy.
When looking at the performance figures of the world's best investors and how they got there, it is important to remember that these figures are dominated by survivorship bias. Yes, the billionaires in the list today might have made most of their money from just one investment or company, but this does not include the hundreds and thousands of other investors who tried to adopt the same approach but lost everything very quickly.
In reality, there is no set formula for the perfect amount of diversification you should have in your portfolio. It depends on how much experience you have as an investor and how much concentration you feel comfortable taking.
Seth Klarman (Trades, Portfolio) on diversification
I recently came across one of Seth Klarman (Trades, Portfolio)'s letter to shareholders of his Baupost hedge fund that attacks this topic of diversification. The letter, dated December 1996, outlines his approach to diversification when accompanied with a value strategy. Here's what he had to say:
"A key component of our investment strategy is sufficient but not excessive diversification. Rather than own a little bit of everything, we have always tended to place our eggs in a few dozen baskets and watch them closely. These bargain-priced opportunities are selected one at a time, bottom up, which provides a margin of safety in case of error, bad luck or disappointing business results. However, we are always conscious of whether these different investments involve essentially the same bet or very different bets. If each of our holdings turned out to involve similar bets (inflation hedges, interest rate sensitive, single market or asset type, etc.), we would be exposed to dramatic and sudden reversals in our entire portfolio were investor perceptions of the macroeconomic environment to change. Since we are not able to predict the future (it is hard enough to understand the present), we cannot risk such concentrated exposures."
This is interesting because Klarman is generally considered to be a concentrated investor. According to Baupost's latest 13F filing with the SEC, Klarman's top five holdings account for 50% of his equity portfolio. The most significant position makes up just under 18% of equity assets.
It seems that Klarman is willing to forgo broad diversification in favor of rigorous, in-depth research. In his letter, after writing the above, he went on to say, "Owning a diverse portfolio in one market may greatly reduce the risk associated with a single company hitting a bump in the road but will not at all reduce the risk of being in that market. If that market runs into a pothole, its components could all break down at once."
Klarman continued, "This is particularly true if that market is trading at record levels of valuation, supported more by money flows than by fundamentals, as happens sometimes."
And after acknowledging that it is not possible to diversify away beta, he went on to say that the best strategy for investors looking to reduce risk is not diversification, but solid fundamental research:
"Of course, diversification is for us only the starting point for risk reduction. Solid fundamental research, emphasis on catalysts, value discipline, preference for tangible assets, hedged short selling, market put options and other strategies combine to create an overall portfolio safety net for our portfolio that we believe is second to none."
Disclosure: The author owns no share mentioned.
