Persuasive Paper Against Portfolio Diversification

Steve Smith, 23, recently out of college, has just won $15 million in the lottery. After buying a few things, he realizes that he still has quite a bit of money, and starts to look at the big picture and what he should do. After his girlfriend shoots down his dreams of buying an island paradise where he could relax and golf all day, or buying his own rocket ship, Steve is forced to think of more practical things to do with his newly acquired fortune. Unable to find a way to spend it all, Steve decides to save and invest most of his winnings. He begins searching financial magazines and the internet for the best way to build his capital.

Steve faces an issue that many investors today face—not a pessimistic girlfriend, but rather how he should invest his money. In his research, Steve has found that there is a commonly accepted investment style that is focused on diversification of risk. Risk in terms of investing is based on the possibility of losing your money. For example, stocks are higher-risk investments where government bonds are considered lower risk, because stocks are shares of ownership to a certain company, which could see hardships at any given time, while government bonds are guaranteed by the country’s treasury to ensure that the investor is paid when the bond is due.

While he was doing all this searching, Steve remembered the time he was going to a Hawaiian party in college, and his searching for clothing ideas from his idol, Jimmy Buffett. In his online search, he came across some other Buffett, named Warren, who he remembers be deemed some “investment guru.” Before he decides to do anything with his cash, Steve decides to see if this Warren guy is the best in his field, just like Jimmy.

Come to find out, he is. Warren Buffett, currently the second richest man alive and CEO of mutual fund company Berkshire Hathaway, owes almost all of his overbearing bank account to personal investments. Buffett is not, however, a traditionalist when it comes to his style of investing; he is a man who does not believe in diversification.

The “traditional” portfolio technique, or so to call it, teaches investors to diversify their risks—simply, to have a balance of stocks, bonds, and other investments that are of varying risk. The logic is that being too heavily invested in stocks could do great harm to an investor if the stock market goes through a tough period; the same is true for less risky ventures: being too heavily invested in bonds will not cost the investor any money, but bonds do not have the potential to show the returns that stocks can.

Trusted investing information companies, MorningStar and Bloomberg, both present subscribers with an education on investing. In Investing 101: Getting a Good Start with a Sound Strategy, Bloomberg says that diversification “helps preserve your portfolio’s value, mainly because some investments rise while others fall.”

Their motivation in saying this is that unforeseeable circumstances can alter performance within and across industries. If an investor’s portfolio was heavily allocated in one stock or industry, poor performance could really hurt the status of the portfolio. Similarly, being diversified can help investors to “capitalize on unforeseeable growth” of a stock or industry and thus increase their portfolio’s value. MorningStar’s educational series gives the same premises for diversification and goes on to say that diversification can create the most “efficient portfolio.”

Warren Buffett does not agree with conventionally diversifying a portfolio, because he feels it does not truly reduce risk. He has gone so far as to say, “risk comes from not knowing what you are doing” (Investopedia.com). Buffett’s own portfolio consists mainly of the same stock holdings as his company’s, Berkshire Hathaway, mutual fund portfolio. His technique is to invest in the stocks of companies that he feels will still be going strong twenty years from now. Buffett looks at the value of a company, which he measures in terms of current performance, some fundamental of the financial statements, and his personal speculation on the company’s future performance.

His lack of diversification is a strong contrast to that of the traditional method; however, this lack of diversification has helped his personal portfolio to outperform market indexes, used as benchmarks for returns on stock market investments, such as the Dow Jones Industrial, the Nasdaq, and the Standard and Poor’s 500 (S & P 500) every year for the past 40 years.

In his article “Warren Buffett: The World’s Greatest Investor,” financial journalist Maynard Patton presents some quotes from Warren Buffett on his investment style. Buffett is attributed with saying “conventional diversification makes no sense for [a know-something investor]. It is apt simply to hurt your results and increase your risk.” Buffett’s rationale is that investors should not buy shares of a stock unless they feel the company they are buying into will be around for a while. To make an assumption that a particular company will still be a functioning body in the future would require some knowledge of the company’s financial situation and the industry in which it operates.

Essentially, Buffett believes that people should only invest in companies with which they are familiar. Along these lines, one of his strongholds is that many people purchase stocks of companies in industries with which they are not familiar for the sake of diversification. Making a less informed choice, to Buffett, is much worse than not diversifying a portfolio.

While their methods differ in terms of how many stocks and which industries to invest in, both Buffett and the “traditional” method have the same aim for portfolios: safety. Buffett’s intuition is that an investor is taking less chances by investing in a company in a familiar industry, where Bloomberg’s idea of security entails covering all possible bases in light of possible good or bad.

Diversification does fundamentally make sense because it helps investors to cover all their bases, but it does have its downfalls. In diversifying their portfolios, investors are often rolling the dice with their money by choosing stocks of unfamiliar companies in unfamiliar industries for the sake of diversifying their investments. Making uniformed choices can be quite dangerous, and in my opinion, and that of Warren Buffett, diversifying a portfolio by means of purchasing unfamiliar companies’ stocks is not a good move.

This is not to say that Buffett’s style is flawless. As the traditional method points out, being heavily invested in one particular company or industry can be detrimental to one’s net worth in times of unforeseeable trouble. Surely Warren Buffett himself could not have predicted events such as the terrorist attacks of September 11, which left a large portion of the market in shambles.

I do feel, however, that Buffett’s style is superior to traditional diversification. The fact that Buffett and his mutual fund, Berkshire Hathaway, have shown returns that continually dwarf those of popular market benchmarks like the S&P 500 (which are very diversified) are plenty of proof to this point. I must warn, however, that not everyone will be able to see such great results, especially when first utilizing this style.

In direct response to the ways of Warren Buffett, Bill Mann, senior editor for investing at the Motley Fool, deems Buffett’s methods to be “a menace” to portfolios. He warns readers that they probably won’t see the same results that Mr. Buffett does basically due to the fact that “they’re not him. And there’s a 99.999% chance that as hard as he has had to work to get where he is, they would have to work much, much harder.”

Mann believes that a large part of Buffett’s success is due not to his style, but his unique experiences—studying under Benjamin Graham, his position in the business world, and his ability to read financial statements and analyze both companies and markets—that enable his style to work for him. He goes as far as to compare Warren Buffett to Michael Jordan: And let’s also face it — the man’s got an innate knack. By comparison, here in Washington, D.C., we just witnessed perhaps the first professional failure of Michael Jordan’s illustrious basketball career.

Having accomplished more than anyone else on a basketball court, he took over as head of basketball operations for our local sad-sack NBA team, the Washington Wizards. What he subsequently learned of the players that he picked to revive hoops in Washington was this: They weren’t him. They couldn’t move like him, they couldn’t think like him, they couldn’t perceive like him…It is the same with Warren Buffett. He’d have an easier time teaching you how to breathe nitrogen than how to invest like him. It would require you to be him.

While Mann doesn’t condemn the Buffett method itself, he condemns the belief that it can work for the average investor. His message is simply that investors need to realize that Warren Buffett, like Michael Jordan, has a rare and unique talent that, though many will try to, few will successfullyemulate.

We cannot argue with Mr. Mann’s assessment that Warren Buffett’s style is indeed the result of his unique learning experiences, but that is not to say that no one else can achieve great results by using his system. Michael Jordan was arguably the greatest player to ever set foot on an NBA court—an argument reserved for a different time—and while none may ever achieve his great status, it does keep others from reaching their own potential and doing very well for themselves in the NBA. In the same light, investors should not pack up their money and quit investing just because they may never be a Warren Buffett, but they too should practice—not free throws, but picking companies with great returns—to become the best investors they can be.

Since Buffett’s fund has vastly outperformed the major market benchmarks for its lifespan, we can rule out luck as the basis for its success and assume that less diversification (when properly employed) yields greater returns. That’s exactly what investors look for—the highest possible returns. As noted by Mann, employing all of one’s assets to an undiversified, Buffett-esque portfolio can be extremely dangerous. This, however, doesn’t mean that investors can’t learn if they can succeed with an undiversified portfolio.

To remedy this dispute, investors may be able to train themselves to trade just like the famed Mr. Buffett, by selecting familiar companies that have solid financials and the speculation to do well in the future. The best way to start is to make a mock portfolio (mock portfolios contain no money, they simply track the performance of a hypothetical portfolio) or invest a small portion of their investing money in a more focused portfolio comprised of a few stocks with which the investor is familiar.

After tracking the results of this alternative portfolio for a given period, the investor can evaluate its performance. In the case of positive results that outperform either the expectations or the current portfolio of the investor, s/he can increase the amount invested in the undiversified portfolio. With negative results, s/he should reevaluate the stock picks and start over. Under these guidelines, an investor can gradually work toward a higher-yielding, less diversified portfolio in a safe manner. Just because someone may not become the best investor ever, doesn’t mean that s/he can’t become great at investing.

This strategy may not work for everyone, which is why it is important to start such a portfolio with little to no money it in, and gradually place more funding in it as the investor gains confidence and knowledge. Not everyone will find their niche in the game that requires astute stock picks, and they will be able to fall back on conventional diversification without losing a step. Those who do find success emulating Buffett will be very prominent market players. They may find themselves wondering why they ever worried so much about diversification in the first place.

As for our friend Steve, three divorces, two Ferraris, and many dollars later he sits back and enjoys margaritas on the sandy beaches of Waikiki and thinks how fortunate he’s been. He realizes that even without winning an eternity’s salary, he could’ve easily found the same wealth in his recently employed investing strategy. While his fortune would’ve accumulated slightly (ok, so maybe a lot) slower, he would have still done quite well for himself.

Despite that, he’s grown even wealthier than anyone at the lottery claims department would’ve ever imagined. Like Buffett, he’s seen greater returns in his portfolio than in any market benchmark, and he’s claimed investing as his occupation ever since he’s found his way. One day he’d like to meet Warren Buffett and thank him for going against the grain. Until then, Steve has no problem living the life and listening to that other Buffett as the tides roll by.

BibliographyBloomberg Online. Investing 101: Lesson 2. 10 March 2004. http://www.bloomberg.com/analysis/univ/tutorial/investing101/lesson2.html.

Investopedia. The Greatest Investors: Warren Buffett. 12 March 2004. http://www.investopedia.com/university/greatest/warrenbuffett.asp.

Mann, Bill. “The Dangerous Warren Buffett.” 4 June 2003. The Motley Fool.15 March2004. http://www.fool.com/news/commentary/2003/commentary030604bm.htm.

Morningstar Online. “Morningstar Investing Classroom Course 503: Modern PortfolioTheory section 3: Diversification and an “Efficient” Portfolio.” 9 March 2004.http://news.morningstar.com/classroom/article/0,3163,4496,00.html.

Patton, Maynard. “Warren Buffett: The World’s Greatest Investor.” 3 April 2002. TheMotley Fool. 12 March 2004.http://www.fool.co.uk/news/foolseyeview/2002/fev020403c.htm.