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Wednesday, October 10, 2007

Diversification is for birds!!

My portfolio consisted of 24 stocks few months back. I have been reallocating the portfolio by reducing the number of stocks I am holding and allocating that capital to the stocks I consider better. As of today, I hold 16 stocks. My target going forward is to limit the holdings between 10-15 stocks.

Why would I do that? After-all diversification is 'the word' we read and hear a lot about. I started thinking about the subject after reading about some of the world's successful investors. I analysed my own portfolio and I am convinced that holding fewer stocks which I consider best investments is a better way to manage risk and to increase returns.

Another advantage of having limited number of stocks and setting an upper limit on number of stocks is that every time we come across a potential investment, we will be forced to evaluate and compare all the stocks in the current portfolio with the new one to find the least desirable investment. It may be one in the current portfolio (in this case we will have to sell the weak investment and buy the new one) or it may be the new investment under consideration (in this case we can eliminate the option of buying the new investment). This will force us to continuously evaluate the holdings & create a very sound portfolio. Read on...

Warren Buffet:
"Many pundits would therefore say the [this] 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."

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"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." - 1993 Chairman's Letter to Shareholders

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."

"If you are not a professional investor, if your goal is not to manage money in such a way that you get a significantly better return than world, then I believe in extreme diversification. I believe that 98 or 99 percent — maybe more than 99 percent — of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all — that is the way they should approach it. "

"We continue to concentrate our investments in a very few companies that we try to understand well. There are only a handful of businesses about which we have long-term convictions. Therefore, when we find such a business, we want to participate in a meaningful way. We agree with Mae West: ’Too much of a good thing can be wonderful.’"

Buffett likens a portfolio of 40 or more stocks as a Noah’s Ark way of investing--you end up with a zoo.

’If you have a harem of 40 women, you never get to know any of them very well.’ At the end of 1999 and 2000 Berkshire had 70% of its investment funds in just four companies. Buffett and Munger concentrate their attention, skills and experienced judgment because it is ’too hard to make hundreds of smart decisions.’

Buffett’s and Munger’s notion of risk differs from that of the standard finance textbooks, because they focus on the possibility of loss and injury. In contrast, academic finance courses focus on the relative volatility of a stock or portfolio of stocks (compared to a large universe of stocks). The two are related, but not identical. As Buffett says: ’For owners of a business--and that’s the way we think of shareholders--the academics’ definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market--as had Washington Post when we bought it in 1973--became ’riskier’ at the lower price than at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?’

George Soros:
"Diversification is for the birds."

Peter Lynch:
"The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four combined go nowhere, you’ve still tripled your money... The part-time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than five companies in the portfolio at any time."

The crucial consideration is allowing enough time to be able to develop and maintain a high level of knowledge about each of the companies. "Owning stocks is like having children--don’t get involved with more than you can handle." All stocks in the portfolio have to pass some stiff tests and you will not know if they pass the tests unless you are able to spend time analyzing them.

Philip Fisher:
"It never seems to occur to them, much less to their advisers, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification."

Fool's article on diversification: http://www.fool.com/investing/value/2007/08/13/why-diversification-can-leave-you-behind.aspx

Credits: http://www.wallstraits.com/main/viewarticle.php?id=854


1 comments:

Asif said...

George buddy,

Your site rocks!!!

have not heard from you for long, still in US/BoA?

Asif