Adequate Diversification

A few words on “adequate diversification” from a legendary hedge fund manager.  Emphasis is our own . . .

Last
year in commenting on the inability of the overwhelming majority of
investment managers to achieve performance superior to that of pure
chance, I ascribed it primarily to the product of: “(1) group
decisions – my perhaps jaundiced view is that it is close to impossible
for outstanding investment management to come from a group of any size
with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3)
an institutional framework whereby average is “safe” and the personal
rewards for independent action are in no way commensurate with the
general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

This
year in the material which went out in November, I specifically called
your attention to a new Ground Rule reading, “We diversify
substantially less than most investment operations. We might invest up
to 40% of our net worth in a single security under conditions coupling
an extremely high probability that our facts and reasoning are correct
with a very low probability that anything could drastically change the
underlying value of the investment.”

We are obviously following a
policy regarding diversification which differs markedly from that of
practically all public investment operations. Frankly, there is
nothing I would like better than to have 50 different investment
opportunities, all of which have a mathematical expectation
(this term reflects the range of all possible relative performances,
including negative ones, adjusted for the probability of each – no
yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum.
If the fifty individual expectations were not intercorelated (what
happens to one is associated with what happens to the other) I could put
2% of our capital into each one and sit back with a very high degree
of certainty that our overall results would be very close to such a
fifteen percentage point advantage.

It doesn’t work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such
a situation by definition is one where my expectation (defined as
above) of performance is at least ten percentage points per annum
superior to the Dow. Among the few we do find, the expectations vary
substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This
depends to a great degree on the wideness of the spread between the
mathematical expectation of number one versus number eight.” It also
depends upon the probability that number one could turn in a really poor
relative performance. Two securities could have equal
mathematical expectations, but one might have .05 chance of performing
fifteen percentage points or more worse than the Dow, and the second
might have only .01 chance of such performance. The wider range of
expectation in the first case reduces the desirability of heavy
concentration in it.

The
above may make the whole operation sound very precise. It isn’t.
Nevertheless, our business is that of ascertaining facts and then
applying experience and reason to such facts to reach expectations.
Imprecise and emotionally influenced as our attempts may be, that is
what the business is all about. The results of many years of
decision-making in securities will demonstrate how well you are doing
on making such calculations – whether you consciously realize you are
making the calculations or not. I believe the investor operates at a
distinct advantage when he is aware of what path his thought process is
following.

There is one thing of which I can
assure you. If good performance of the fund is even a minor objective,
any portfolio encompassing one hundred stocks (whether the manager is
handling one thousand dollars or one billion dollars) is not being
operated logically. The addition of the one hundredth stock simply
can’t reduce the potential variance in portfolio performance
sufficiently to compensate for the negative effect its inclusion has on
the overall portfolio expectation.

Anyone owning such
numbers of securities after presumably studying their investment merit
(and I don’t care how prestigious their labels) is following what I
call the Noah School of Investing – two of everything. Such investors
should be piloting arks. While Noah may have been acting in accord with
certain time-tested biological principles, the investors have left the
track regarding mathematical principles. (I only made it through plane
geometry, but with one exception, I have carefully screened out the
mathematicians from our Partnership.) Of course, the fact that someone
else is behaving illogically in owning one hundred securities doesn’t
prove our case. While they may be wrong in overdiversifying, we have to
affirmatively reason through a proper diversification policy in terms
of our objectives.

The optimum portfolio depends on the
various expectations of choices available and the degree of variance
in performance which is tolerable. The greater the number of
selections, the less will be the average year-to-year variation in
actual versus expected results. Also, the lower will be the expected
results, assuming different choices have different expectations of
performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of “results,” I am talking of performance relative to the Dow)
in order to achieve better overall long-term performance. Simply
stated, this means I am willing to concentrate quite heavily in what I
believe to be the best investment opportunities recognizing very well
that this may cause an occasional very sour year – one somewhat more
sour, probably, than if I had diversified more. While this means our
results will bounce around more, I think it also means that our
long-term margin of superiority should be greater.

You
have already seen some examples of this. Our margin versus the Dow has
ranged from 2.4 percentage points in 1958 to 33.0 points in 1965. If
you check this against the deviations of the funds listed on page
three, you will find our variations have a much wider amplitude. I
could have operated in such a manner as to reduce our amplitude, but I
would also have reduced our overall performance somewhat although it
still would have substantially exceeded that of the investment
companies. Looking back, and continuing to think this problem through, I
feel that if anything, I should have concentrated slightly more than I
have in the past. Hence, the new Ground Rule and this long-winded
explanation.

Again let me state that this is somewhat
unconventional reasoning (this doesn’t make it right or wrong – it does
mean you have to do your own thinking on it), and you may well have a
different opinion – if you do, the Partnership is not the place for you.
We are obviously only going to go to 40% in very rare situations –
this rarity, of course, is what makes it necessary that we concentrate
so heavily, when we see such an opportunity. We probably have had only
five or six situations in the nine-year history of the Partnership
where we have exceeded 25%. Any such situations are going to have to
promise very significantly superior performance relative to the Dow
compared to other opportunities available at the time. They are also
going to have to possess such superior qualitative and/or quantitative
factors that the chance of serious permanent loss is minimal (anything
can happen on a short-term quotational basis which partially explains
the greater risk of widened year-to-year variation in results). In
selecting the limit to which I will go in anyone investment, I attempt
to reduce to a tiny figure the probability that the single investment
(or group, if there is intercorrelation) can produce a result for our
total portfolio that would be more than ten percentage points poorer
than the Dow.

We presently have two situations in the over 25%
category – one a controlled company, and the other a large company
where we will never take an active part. It is worth pointing out that
our performance in 1965 was overwhelmingly the product of five
investment situations. The 1965 gains (in some cases there were also
gains applicable to the same holding in prior years) from these
situations ranged from about $800,000 to about $3 1/2 million. If you
should take the overall performance of our five smallest general
investments in 1965, the results are lackluster (I chose a very
charitable adjective).

Interestingly enough, the
literature of investment management is virtually devoid of material
relative to deductive calculation of optimal diversification. All texts
counsel “adequate” diversification, but the ones who quantify
“adequate” virtually never explain how they arrive at their conclusion.
Hence, for our summation on overdiversification, we turn to that
eminent academician Billy Rose, who says, “You’ve got a harem of
seventy girls; you don’t get to know any of them very well.”

Warren E. Buffett, 1966 Annual Letter to Limited Partners

Comments

[Geoff-UK]

What Don said.

Also, don't believe Buffett's hype when he's on the boob tube.  He's talking his book and that's it.  Mute the volume if you just like looking at him when he's on TV.

[TideFighter]

Don't forget that tech-jewel on the road, Harley Davidson. The ironic, cyclonic, iconic, soon to be bubonic, motorcycle company. Berky got a big bailout on that one too.

[Oquities]

so 20% nat gas, 10% large cap dividend, 45% cash & eqivalents, 15% land & agriculture.  (PMs off-balance sheet in personal SIV).

[Don Birnam]

Thirty percent of Berkshire's equity portfolio were firms which were direct recipients of taxpayer-funded TARP bailout/life support monies ( GS, USB, WFC, AXP ).

"This isn't your father's Berkshire Hathaway."