Thursday, September 29, 2016

Concentration: the case for putting all your eggs in one basket

This article was first published in the Financial Times, FTfm, on September 30, 2013; Co-author: Khemchand Sakaldeepi

http://www.ft.com/cms/s/0/d4e511fc-250f-11e3-bcf7-00144feab7de.html#axzz2gLgr9ACE

Is diversification the best way to invest in the market today? Not really. The portfolios of major investors worldwide make the case for another, often-ignored, strategy: concentration. Business schools need to refrain from pushing the merits of diversification without highlighting the efficacy of concentration.

“Do not put all your eggs in one basket. Diversify.” In 1952, investment aspirants received this clarion call from Harry Markowitz, a US economist and Nobel laureate. Peter Lynch, the famous US businessman and stock investor, “never saw a stock he didn’t like” and was a great proponent of portfolio diversification. While managing the Magellan fund, at the peak of his career, Mr Lynch’s portfolio had more than 1,000 stocks. To date, portfolio diversification remains the most important lesson taught to students of investment and risk management. The concept is a common thread in the investment approach of most fund managers and investors.

However, if we look at the portfolios of the rich and famous, they are, surprisingly, mostly concentrated. Several great investors, spread across geographies, have very concentrated portfolios. Warren Buffett, George Soros, Rakesh Jhunjhunwala and many others are renowned proponents of portfolio concentration. To Mr. Buffett, over-diversification presented a “low-hazard, low-return” situation and thus he dismissed it. A concentrated portfolio pivots on the absolute conviction of the investor in his or her stocks and his or her risk appetite.

A diversified portfolio, on the other hand, works well if the investor is optimistic about the stock, but wary of the associated risk. Investors like the first billion-dollar Indian investor, Mr. Jhunjhunwala, walk a fine line between the two.

John Maynard Keynes, the influential British economist, was another staunch supporter of concentration. “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes,” he once said.

Mr. Buffett, echoing Benjamin Graham, the father of “value” investing, says he does not just buy an insignificant thing that bounces by a small percentage every day on the stock market. He buys part of a real business and thinks like the owner of a business would.

Mr. Buffett says: “Wide diversification is only required when investors do not understand what they are doing.” Bruce Berkowitz, founder of Fairholme Capital and a leading “value” proponent, adds that just a handful of significant positions are enough to do unbelievably well in a lifetime.

In 2012, the results of a study from the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, University of Technology Sydney, showed that if skilled fund managers invested in concentrated portfolios, they would improve their performance markedly as compared with the portfolios that they would build under the compulsion to diversify. Despite mitigating stock-specific risks, the method of diversification cannot fortify the portfolio against market risks.

Advocates of concentration also opine that building or creating wealth with a diversified portfolio is difficult, unless the entire market is experiencing a bull phase and all the stocks in the portfolio are performing well. Even then, you may not get the full advantage of a multi-bagger as your investment in that particular stock would be just a fraction of your entire portfolio. The anti-diversification camp proposes that to generate wealth some concentration is required, provided people know how to assess their risk appetites and simultaneously pick winning stocks.

Fund managers today are caught in a catch-22 situation. Is wealth generated first by diversification and then maintained through concentration or vice versa? Knowing that concentration has been the mantra for success for most investment gurus, is it savvy to jump on the “diversification bandwagon” by adhering to popular belief? Awareness of such dilemmas and seeking clarity on them is essential for future managers.

It is, thus, time for business schools to introduce concentration as an important strategy in wealth creation, management and enhancement. Special attention needs to be given to this in business pedagogy, as the training of financial advisers and finance students will remain incomplete if it is restricted to the hallowed realm of diversification as the only plausible investment strategy.
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