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.