Sunday, 17 December 2017

Portfolio concentration can produce better results than diversification.

Portfolio concentration can produce better results than diversification due to a number of factors, including 

  • lower transaction costs—broker commissions proportionately decrease as deal size increases— and
  •  potentially lower administration costs. 
But perhaps the most compelling argument for portfolio concentration by informed investors is the simple logic expressed in one of Warren Buffett’s shareholder letters:
I cannot understand why an [educated] investor . . . elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices—the businesses he understands best and that present the least risk, along with the greatest profit potential. 
The same impulse that propels stock market speculation also motivates the drive toward diversification—the desire to be part of the crowd.

As the financier Gerald Loeb recognized, a widely diversified portfolio “is an admission of not knowing what to do and an effort to strike an averagefor those investors who believe that they can in fact rank stocks, a policy of portfolio concentration is preferable.  

Keeping It Simple
Diversification is, in reality, more a strategy of risk dispersion than risk reduction.

Keynes’ response to uncertainty and risk in the share market was radically different to the prevailing wisdom—as he explained in a letter to one of his business associates:
 . . . my theory of risk is that it is better to take a substantial holding of what one believes shows evidence of not being risky rather than scatter holdings in fields where one has not the same assurance.

To ascertain which stocks “show evidence of not being risky,” the value investor searches for those securities that exhibit a sufficiently large margin of safety—that is, those stocks with a substantial gap between estimated intrinsic value and the quoted price.

In undertaking this analysis, the intelligent investor will necessarily focus only on those businesses he or she understands. Keynes noted that he would prefer “one investment about which I had sufficient information to form a judgment to ten securities about which I know little or nothing.” His contention was that intelligent, informed investors will reduce their downside risk by scrutinizing only those sectors within their “circle of competence” —to use Buffett’s phrase—and then only investing in those stocks which exhibit a satisfactory margin of safety. 

Like Socrates, the intelligent investor is wise because he recognizes the bounds of his knowledge  

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