The "Painful" Truth About Portfolio DiversificationPortfolio / Learning to Invest Oct 31, 2013 - 03:11 PM GMT
Robert Hsu writes: Portfolio diversification is one of the most widely advocated concepts in investing. Almost all financial planners recommend it.
But it's also one of the most misunderstood concepts.
Traditional diversification isn't a real-world way to create big wealth.
Warren Buffett certainly understands this, as you'll see.
So does Lynn...
The Best Investors in the World
After 23 years in the business, I can say that most investors I've met, who've made serious money in the market, have done so through a focused portfolio with just a handful of highly concentrated equity positions.
For example, Lynn, a billionaire heiress I know, inherited most of her wealth in the form of one single stock.
That stock was Warren Buffett's Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B)
In the 1950s, Lynn's late husband invested $1 million with Warren Buffett. The combination of time, and of course Buffett's expertise, allowed that money to grow exponentially. Lynn and her husband eventually became one of the largest shareholders in Berkshire Hathaway.
Even after selling half of their holdings in the 1980s, Lynn's husband still had enough Berkshire Hathaway stock to make the Forbes 400 list of the richest Americans during the 1990s.
Interestingly, one of the keys to Warren Buffett's success is the fact that he advocates against diversification. Buffett believes, as we do, in taking concentrated positions in a handful of carefully researched holdings, and that is part of why he's considered one of the greatest investors of all time.
So why do so many investment managers and advisors advocate a policy of broad asset diversification despite the Oracle of Omaha's successful model?
I think the answer is threefold...
As strange as it may sound, one of the reasons that diversification is popular is our litigious society. Financial advisors, financial planners, and money managers are justifiably afraid of getting sued in the event of a market blow-up that causes client asset values to plunge.
This fear of litigation also forces advisors to lean toward being more conservative with client funds. As a money manager, I know many of the top attorneys in the business, and they all advise cultivating a defensive mentality when managing client assets.
Then there's the matter of "upbringing." It's a fact that an entire generation of MBAs has been taught the concepts of Modern Portfolio Theory (MPT), which essentially touts the benefits of diversification. The theory advocates measuring return adjusted by volatility. Thus the more stable the investment, the more desirable the investment. Because diversification helps lower overall volatility, it has become a primary goal for MPT practitioners.
And finally, there's the fact of leverage, as used by many Wall Street trading operations. The riskier leveraged strategies can make big bucks, but they can also come down hard.
For example, a strategy that leverages trading accounts by five-to-one could be wiped out by a 20% decline. By advocating diversification - along with the leveraged strategies - investment banks (like my alma mater, Goldman Sachs) and hedge funds can effectively hedge out much of the downside that can come with swinging for the fences using leverage. And leveraged positions are where the really big money is made.
Of course, few of us have trading desks at Goldman Sachs. But, then again, we don't have to have them to swing for the fences.
Ask Yourself These Three Questions
For individual investors, the question of whether to follow Wall Street's diversification model actually depends on how realistic our objectives are, and more importantly, how much tolerance you may have for downside volatility.
It's important to be introspective, to ask yourself tough questions, and then answer honestly. Questions such as:
Can I sit through periodic drawdowns of 30% or more in a holding?
Can I go for years with a paper loss that bites into my overall wealth picture?
Do I value capital growth over capital preservation?
If you say "no," then you are a candidate for diversification.
If, however, you have a high risk tolerance, and if you are unafraid of facing volatility in exchange for the prospect of creating big wealth like Lynn and her husband, then I think it is better to focus on building a concentrated investment portfolio of the best securities around.
The painful truth here is that, while having a diversified portfolio is right for some investors, it's also not the best way to build huge wealth.
If you're seeking long term, market-crushing results, you've got to take more risk even as you're more selective about your holdings. And, most importantly, ignore Wall Street's "diversification" mantra.
If you're ready to begin concentrating your money for maximum gains, start by reading more about Robert's recommendations.
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