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Concentration vs. Diversification
By JLP | November 17, 2005
On my post Mortgage Your Retirement, my friend Jesse left the following comment:
JLP, what are your thoughts on Warren Buffet’s strategy of not diversifying, but making sure you really understand what you’re investing in. I think his mentor (Graham?) is the one that said you can identify a company where you are virutally guaranteed a profit. That thought intrigues me – and I wanted to get your opinion.
I call this concentration vs. diversification. Concentration (owning a small number of securities rather than an index or mutual fund) can be a good strategy IF you know what you are doing. The problem is, most people DO NOT know what they are doing when it comes to investing. Or, even if they do know what they are doing, they allow their emotions to make decisions for them, which can be deadly to their investment plans.
Of course their are different forms of concentration. For instance, a person could choose to invest in a small number of individual stocks rather than an index fund. Another form of concentration is owning certain sectors of the market rather than the entire market. With the advent of exchange-traded funds (ETF), this form of concentration is easy to execute. For example, the Dow Jones Total Market Index is broken down into the following ten sectors (with their ETF symbol in paranthesis):
So, if you thought that not all areas of the market were going to perform well, you could buy only those ETFs that you thought would do well and ignore the rest. This is a form of concentration, though not quite as risky as buying individual stocks.
Personally (and Warren Buffett agrees), I think the average person should utilize indexing for the bulk of their portfolio. It is highly unlikely that the average person could do as well as Warren at picking stocks themselves. Keep in mind that stock picking is his life. He has dedicated his life to investing, whereas the average person cannot do that. Therefore, the average person should concentrate on asset allocation, indexing, and investing as much money as they can afford and leave the individual stock picking to the pros.
I’m curious as to what you, my readers think. Opinions?
Topics: Investing | 3 Comments »
November 17th, 2005 at 3:25 pm
Another thing to consider is that Warren Buffett is not simply an investor–he is a business man. When Buffett buys into a business, he takes an active role managing/deciding the future of the company.
November 18th, 2005 at 4:36 pm
Good point by Aaron. Thanks for the insight JLP. I do think that if you’re going to be a concentrated investor, you’ll need to spend a significant amount of your time researching and deciding what to invest in. I’m a fan of the index funds as a core strategy (Vanguard Target Retirement Funds have my fancy), but also enjoy investing in single stocks whose products I thoroughly enjoy/admire (AAPL). Of course, this is done w/ money I can afford to lose.
April 10th, 2010 at 1:37 pm
It would seem however that concentration combined with value investing would be the way to go, if you have professionals chosing the stocks for you.
Picking companies with niche markets and “moats” along with the other fundamentals would seem also to reduce the risk potential.