If you were to go to a restaurant today and order some food, would you order one of everything on the menu, or would you just order a few of the things you really knew that you liked? Chances are—and I might be taking a big leap here—that you would know what you liked for whatever reason (taste, healthiness, price), and would order just a few of those things, rather than thinking you had to have one of everything on the menu. Maybe I’m in the minority here, but that course of action seems to make the most sense to me.
Yet in the investment world, most folks seem to be encouraged to have one of everything off of the proverbial financial menus that larger financial firms offer. The reason typically given for promoting this type of behavior, is that the more investment products one has, the more that person’s portfolio is diversified. This assumes, of course, that diversification is something that should be universally desired among all investors. But does this really make sense?
At first blush, diversification seems like a good idea. In theory, when one investment declines in value, another less correlated investment should tend to rise in value, leaving the investor’s portfolio somewhat unchanged. While this should generally make folks feel better about their portfolios, to me at least, it doesn’t make a lot of sense from an investment perspective. For example, if the aim of a diversified portfolio—a likely moving definition—is to protect investors on the downside, the natural corollary to this, is that investors are giving up the potential for gains as well. And if an unchanged portfolio is the typical outcome of a diversified portfolio, why pay the huge fees of various investment products sold by larger firms? Why not just hold cash?
But I think that in some cases that this “diversification” mantra can be even worse than only holding cash. How many of your portfolios were supposed to be fully diversified over the last year, and even so, they are now worth 40-50% less than they were two years ago? Not much of a ringing endorsement, if you ask me. In times of crisis—just when diversification is needed most—all the correlations of the different investment products tend to converge to one, thereby reducing an investor’s downside protection. In this case, folks would have even been better off holding cash, and what’s more, they wouldn’t have had to pay all those fees to their “financial advisors”—a euphemism for sales person--for their various investment products.
A couple of years ago at the Berkshire Hathaway (BRK-A) annual meeting, an attendee asked Berkshire Vice-Chairman Charlie Munger a question about the merits of diversification in investing, and Munger sagely advised, “The whole secret of investment is to find places where its safe and wise not to diversify.”
If one thinks about this, what Munger is actually saying is that the notion of diversification--as most “financial advisors” interpret it--is nothing but hogwash. Rather, the advice he is imparting in the first part of that statement is that investors should search for a few businesses or securities where the margin of safety is so great—or said another way, the price is so low—that it is highly unlikely for an investor to lose money. Downside protection, in this case, is not contingent on a group esoteric correlations, but rather by the price you pay for a particular investment.
In the “wise” part of the statement, Munger is implying that if you can find a few investments with upside potential, where you understand the business or security so well that you have an edge over others, it would behoove an investor to make that a larger investment in their portfolio, as long as the price paid for the investment has a large enough margin of safety.
And, in my opinion, this approach to investing espoused by Munger is actually better than even diversification in theory, as it gives investors both downside protection as well as the potential for huge upside for their portfolio.
My best wishes to you and yours for a happy and safe Fourth of July holiday.
I welcome dialogue with my readers, so please send me any questions and comments you have. Also, if you haven’t already done so, please be sure to sign-up for my free email alerts by emailing me at BuffettInsights@gmail.com.
Justin
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The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.
