Sometimes expert advise just makes your head spin, doesn’t it! How many times have you heard an expert touting the advantages of risk-reduction through diversification. Of course, the biggest proponents of diversification, and those with the ad spending budget to brainwash millions of investors, are the mutual fund or unit trust gurus–from banks to Internet fund-selling sites, all preaching the indisputable value of a widely diversified portfolio.What is seldom heard are two divergent facts, each stabbing the fund manager in the heart:Fact one, while diversification does dilute the effect of one bad investment decision, it also dilutes the affect of one good investment decision–thus ensuring mediocraty, and guaranteeing underperformance after fund fees.
Fact two, the world’s greatest investor, Warren Buffett does not diversify– in fact, he practices the exact opposite, a focused investment strategy.
Hollywood has created the image of a professional money manager as running between meetings with two mobile phones in hand, frantically taking notes with one eye glued to a bank of computer screens streaming live news and prices, making instinctive key decisions every five minutes or so. Warren Buffett is far from this picture, lazily strolling out for a cherry Coke and burger between annual report studies in the lathargic small-town American city of Omaha, Nebraska. He has a computer, but spends more time playing virtual bridge than watching news and prices. He doesn’t make decisions every five minutes, but maybe once or twice a year.Buffett-style focus investing is remarkably simple in design, and yet, like most simple ideas, it rests on a complex foundation of interlocking concepts. The world of professional money managers is locked in an epic battle between active portfolio management and passive indexing. Active managers try to use their stock-picking and asset allocation skills to beat the market index. Each day or week, fund investors dial in to see how their portfolio is doing–if the fund beat the market they will leave their money alone, but if it fell behind they may consider shifting to another hot fund or give up altogether and buy the passive lower-cost index fund (which eventually beats at least 7 of 10 active managers). Active fund managers are forced to guess stock prices in the near-term in order to win this losers game.Active managers tend to hold an average of 100 stocks in their funds and generate 80% annual turnover of these holdings, while and an index fund such as the S&P 500 tracking index holds 500 stocks but with a buy-and-hold strategy. Both approaches are sold to investors as an essential way to invest in the high-risk stock markets through a cost-effective broadly diversified approach. After all, who could afford the transaction costs on a 100 to 500 stock portfolio with high annual turnover? Yes, who indeed, including fund investors?Warren Buffett, when discussing the decision between active fund management and passive indexing, unhesitatingly picks indexing. So should investors with a low risk tolerance and no desire to spend their time learning about the economics of individual businesses but still desire to participate in common stocks. As Buffett says, By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. But he is quick to point out that there is a third alternative, a very different kind of active portfolio strategy that significantly increases the odds of beating the index. That alternative is called focus investing.FOCUS INVESTING is a new choice. Reduced to its essence, focus investing means this: Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investents in those stocks, and have the fortitude to hold steady during any short-term market gyrations. To be cliche, put all your eggs in just a few baskets and watch those baskets very carefully.
Finding Outstanding Businesses
Warren Buffett has developed a way of choosing companies that, in his view, are worthy places to put his money for many years. His way rests on a notion of great common sense: If the company itself is doing well and is managed by smart people, eventually its inherent value will be reflected in its stock price. Buffett thus devotes most of his attention not to tracking share price but to analyzing the economics of the underlying business and assessing its management. This process involves a set of investment principles of tenets, as discussed in a previous article.Buffett is a highly rational man. Probability theory, which comes to us from the field of mathematics, is one of the underlying concepts that make up the rationale for focus investing. The focus investor follows a methodical investment process that inevitably identifies good companies with a long history of superior performance and stable management, and this stability points toward a high probability that they will perform in the future as they have in the past. In Asia, many promising businesses are younger than in the US or European market, so a focus on intelligent capital allocation by management and the stability and predictability inherent in a particular industry are good substitutes for long track records.
Less Is More
Remember Buffett’s advice to a know-nothing investor, to stay with index funds? What is more interesting for WallStraits viewers I’m sure is what he says next: If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification (broadly based active portfolios) makes no sense for you.What’s wrong with conventional diversification? For one thing, it greatly increases the chances that you will buy something you don’t know enough about. Know-something investors, applying the Buffett tenets, would do better to focus their attention on just a few companies: 5 to 10 (notice our WS 8 Portfolio targets this range). More important than the actual number of companies in your portfolio is understanding the principle behind it. Focus investing falls apart if it is applied to a large portfolio containing dozens of stocks.
The Focus Investor’s Golden Rules
Concentrate your investments in outstanding companies run by strong management.Limit yourself to the number of companies you can truly understand. Ten is a good number; more than 20 is asking for trouble.Pick the very best of your good companies, and put the bulk of your investment there.
Think long-term: 5 to 10 years minimum.