Why most of us should diversify-- Warren Buffett

[cardude]

I was in the "concentration" camp for years, but now I realize when you start to draw down on your investments they better be diversified:

A question for Buffett for a recent interview:
With the popularity of "Fortune's Formula" and the Kelly Criterion, there seems to be a lot of debate in the value community regarding diversification vs. concentration. I know where you side in that discussion, but was curious if you could tell us more about your process for position sizing or averaging down.

Buffett's answer:
I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. “Lebron James” analogy. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.

Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.

In stocks, it’s the only place where when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonalds reduces the price of hamburgers, I think it’s great.

 

[W2R]

That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it.

If Buffett means what I think he means, then he is saying to DCA into a fund instead of investing the same money into it as a lump sum. That goes against what some people have suggested on the board, so I think it is interesting.

I still like the idea of DCA'ing into equity index funds because it makes sense to me. I haven't been persuaded otherwise (at least not yet).

Of course, maybe that isn't what Buffett meant. One would think that plain English would be easy enough to interpret. Also, I wonder what he means by slowly. Over a year?

 

[travelover]

If Buffett means what I think he means, then he is saying to DCA into a fund instead of investing the same money into it as a lump sum. That goes against what some people have suggested on the board, so I think it is interesting.

I still like the idea of DCA'ing into equity index funds because it makes sense to me. I haven't been persuaded otherwise (at least not yet).

Of course, maybe that isn't what Buffett meant. One would think that plain English would be easy enough to interpret. Also, I wonder what he means by slowly. Over a year?

I think "most" people don't have an alternative to DCA - they invest in bits and pieces as they earn it. I suspect that is what WB is referring to.

 

[cardude]

Here is the link to the entire Buffett interview if yall are interested. Pretty good stuff..........

http://undergroundvalue.blogspot.com/2008/02/notes-from-buff...

 

[haha]

If Buffett means what I think he means, then he is saying to DCA into a fund instead of investing the same money into it as a lump sum. That goes against what some people have suggested on the board, so I think it is interesting.

I still like the idea of DCA'ing into equity index funds because it makes sense to me. I haven't been persuaded otherwise (at least not yet).

Of course, maybe that isn't what Buffett meant. One would think that plain English would be easy enough to interpret. Also, I wonder what he means by slowly. Over a year?

That is what he meant, he spells it right out. Don't buy at the wrong place or the wrong time. Buy a cheap index fund and slowly DCA into.

The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

I cannot understand the negative take on diversification-over- time from some posters here. Why would diversification over asset classes and securities be important, but not diversification over time?

As to how long, he doesn't say. But for me, one year would not be long enough. What if your year ran from March 1999 to March 2000? Your results almost 10 years later would still not look very good.

Ha

 

[youbet]

Your understanding of risk and of probability continue to amaze Mr Ha.

 

[RunningBum]

I cannot understand the negative take on diversification-over- time from some posters here. Why would diversification over asset classes and securities be important, but not diversification over time?

Because in many cases they are mutually exclusive.

If I get a lump sum payment from an inheritance, business sale, house sale, whatever, suddenly I am very heavy in cash. My choice is to immediately try to get to whatever asset distribution I want to have, which means lump sum buying, or DCA'ing my purchases, which means it takes much longer to get to the asset mix I want.

My own preference is to get to the asset mix I want as quickly as possible. If I have an asset distribution that I think is ideal to manage risk while optomizing return, I want to get to that point right away rather than drag along as some less than ideal mix.

This is very much along the strategy of using DCA with your monthly investments. Rather than build up cash to buy in bulk, which will leave you heavy in cash until then, you continually purchase and keep your asset mix roughly in balance.

 

[haha]

Because in many cases they are mutually exclusive.

If I get a lump sum payment from an inheritance, business sale, house sale, whatever, suddenly I am very heavy in cash. My choice is to immediately try to get to whatever asset distribution I want to have, which means lump sum buying, or DCA'ing my purchases, which means it takes much longer to get to the asset mix I want.

My own preference is to get to the asset mix I want as quickly as possible. If I have an asset distribution that I think is ideal to manage risk while optomizing return, I want to get to that point right away rather than drag along as some less than ideal mix.

This is very much along the strategy of using DCA with your monthly investments. Rather than build up cash to buy in bulk, which will leave you heavy in cash until then, you continually purchase and keep your asset mix roughly in balance.

This is an interesting point. I guess if you consider cash as asset like any other, which needs to be in proper balance to avoid large losses due to over concentration in one asset class, then your approach is best.

I don't look at cash that way. Although over time, too much cash is indeed a drag on ones's reurns, it can't hurt you much over shorter time periods. For me, the avoidance of truly horrible timing decisions trump the need to keep to a theoretically derived asset allocation.

Also, I should say that I am after absolute returns. I really don't care if during the time that I am heavy in cash I should lag some benchmark or other. My only benchmark is the need to fund my retirement.

Ha

 

[Nords]

I was in the "concentration" camp for years, but now I realize when you start to draw down on your investments they better be diversified:

Well, if I read five newspapers and a dozen financial reports a day I'd probably be a better investor too. I'd be a miserable human being but I'd be much more informed.

I think Buffett's advice boils down to "Kids, I'm a hardwired & trained professional-- don't try this at home." He also greatly overlooks the potential of his connections forged through of nearly five decades of publicity & shareholder's meetings, especially the last few years with CNBC. I doubt Walter Schloss' or Dick Ruane's phones ring anywhere near as much.

Having said that, I think diversification only does two things: reduce volatility and improve sleep. Its purpose is the same whether you're retired or working, and it's all a function of where your steady cash flow is coming from-- a paycheck, a pension, a cash stash, or some other dividend stream. If you don't have any of those providing the spending money then, yeah, diversification is probably a good idea.

If I was on my own and keeping my expenses reasonably close to my govt pension then I'd be greatly tempted to hold Berkshire as the majority of my portfolio-- at least 50%.

 

[cute fuzzy bunny]

Why would diversification over asset classes and securities be important, but not diversification over time?

Because the data says that (providing things arent obviously ridiculously overpriced like 1999) going all-in is your best bet. Since the vast majority of market days are up days, the longer you take to DCA in, the more you're going to miss out.

Its easy to cherry pick the horrible time periods and use those as a watch word.

On the other hand, I'm a close follower of being fully invested but diversifying those investments into out-of-favor segments as they become available. Cant lose that bargain shopper thing...

 

[DblDoc]

I'd have to agree with RB on this one. If you believe your AA is the most important factor in determining your return then lump summing into that makes the most sense. Sure your timing may be bad for one or more assets but unlikely it would be for all. But again as others have pointed out this (like your AA) is a "how are YOU going to sleep at night" decision.

DD

 

[Milton]

Nothing new here. Buffett's answer is entirely consistant with what he's been saying for (at least) the past 15 years: if you know what you're doing, a focused portfolio of stocks is great, but if you're a "know-nothing investor", you should stick to indexing. See his Chairman's Letter - 1993.

I was in the "concentration" camp for years, but now I realize when you start to draw down on your investments they better be diversified

You may or may not be correct, but there is nothing in your Buffett quotation that leads to that conclusion.

 

[cardude]

You may or may not be correct, but there is nothing in your Buffett quotation that leads to that conclusion.

No, nothing in that quote.......thanks for pointing that out so nobody gets confused.

Here's what I'm talking about. When I was accumulating, I never thought volatility equaled risk. Heck, more volatility usually meant I could pick up more shares of whatever I was looking at for a better price, so I actually liked the volatility.

Now I'm coming around to the fact that volatility does in fact = risk when you have to draw down the portfolio, and I'm also getting older and I'm just not as brave. I actually never really thought about the mechanics of drawing down the portfolio at all when I was saving like crazy.

nothing new here

Well, I though this info was interesting, and pretty "new" and timely:

What we are seeing is a huge repricing and evaluation of risk, correcting for problems of the past. I don’t know of good credit propositions that are going unfulfilled. There’s lots of cheap credit for sensible deals, which I don’t define as anything that happened over the last 12, 18 months. A lot of things that didn’t make sense are being washed out of the system. It is painful for bad decisions. Comparatively, this is not a credit crunch. In 1982 the prime rate was 22% and money was very expensive. In the late 60’s, we made a sound deal there wasn’t any money to be had. That’s not the case now. The Fed has opened the window, and rates are down. It doesn’t mean there won’t be a major recession.

 

[al_bundy]

for anyone interested, Warren Buffet will be on CNBC's morning show Sqwack Box on MOnday answering viewer questions for 3 hours. you can email a question through the website

 

[cardude]

Warren Buffet will be on CNBC's morning show Sqwack Box on MOnday answering viewer questions for 3 hours. you can email a question through the website

That's also new and interesting. Over the last year or so Buffett has been aggressivly promoting his business and his views on CNBC much more than usual. I think it's to help get the point out to owners of businesses the message that he should be the one to call when you want to sell your (large) business and keep it in tact for the sake of employees and for legacy reasons.

Plus, I think he likes hanging out with Becky Quick........

 

[Milton]

Warren Buffet will be on CNBC's morning show Sqwack Box on MOnday answering viewer questions for 3 hours

Personally I don't bother watching Warren Buffett, since the questions he's asked and the answers he gives are pretty much always the same. That's not to suggest that the questions or answers are banal, but once is sufficient. Just Google "Warren Buffett video" and you can easily access several extended Q & A sessions at your leisure.

Over the last year or so Buffett has been aggressivly promoting his business and his views on CNBC much more than usual. I think it's to help get the point out to owners of businesses the message that he should be the one to call when you want to sell your (large) business and keep it in tact for the sake of employees and for legacy reasons. Plus, I think he likes hanging out with Becky Quick.

I agree, on both counts!

 

[al_bundy]

That's also new and interesting. Over the last year or so Buffett has been aggressivly promoting his business and his views on CNBC much more than usual. I think it's to help get the point out to owners of businesses the message that he should be the one to call when you want to sell your (large) business and keep it in tact for the sake of employees and for legacy reasons.

Plus, I think he likes hanging out with Becky Quick........

except for Geico i don't think i ever buy anything from any of his companies. not really sure why he buys all these companies and doesn't really integrate them or do anything else except let them run as separate companies. you can build a mall with retail stores that buffet owns.

OT but there was an internet rumor that maria bartiromo cheated on her husband with some CEO she was interviewing

 

[Nords]

Over the last year or so Buffett has been aggressivly promoting his business and his views on CNBC much more than usual.

I think he feels like the business is finally going to work out OK so he's ready to take a victory lap or two.

Or else someone pulled him aside-- perhaps one of the Gates-- and said "Hey, Warren, you need to buff up your image so that people stop worrying about this succession problem. Now that you and Suzie don't have that living-apart problem and since you've married Astrid, you should get out more into the public eye so that they can't claim you're suffering from dementia or Alzheimer's. Get one of these young media babes to start hanging around you and calling you a Superman, gushing about how you can last all night on the executive jet... analyzing financial reports."

 

[megacorp-firee]

I can't remember where on this board it was stated, but it was a quote that went along the lines of, missing the top x number of up market days and you will miss out on the majority of the upswings that will make your portfolio grow.
I have also seen statistics on yty growth of mutual funds versus investors actual growth rates. The latter is less than the former due to investors buying and selling at the wrong times.

So my leaning is to get fully invested (lump sum) if I am moving money around in my portfolio. Of course I DCA'ed when I was w*rking with monthly contributions to my 401K and taxable accounts. but it was more of a 'forced DCA' since i was paid on a semi-monthly basis.

If I received an inheritance, I would most probably lump sum invest it to keep my AA in line.

 

[al_bundy]

is there a mathematical proof?

th largest up days of the last 10 years have taken place 2000 - 2002 and in the last 6 months

 

[chinaco]

That is what he meant, he spells it right out. Don't buy at the wrong place or the wrong time. Buy a cheap index fund and slowly DCA into.

The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

I cannot understand the negative take on diversification-over- time from some posters here. Why would diversification over asset classes and securities be important, but not diversification over time?

.....

Ha

I DCA when i move money most times even when I could lump sum invest. I do not trust my ability to read the economy. My experience has been that I get it wrong more than right when it comes to trying to time it.

While the quote from Buffet did not state it, I suspect he is getting at the negative affect of dumping money into hot investments (sectors or companies). By the time the average investor recognizes the investment is hot, it often has already peaked or most of the run is over. DCA mitigates the risk.

 

[haha]

Seth Klarman Weighs In

I admit that to me "academic finance" is an oxymoron. I think it is very useful if you are designing or selling some sort of leveraged derivative to others, or buying the same strictly with OPM.

I think academic finance is also useful to FPs and other financial salespeople, in that a simplified version of it is easily explained, has authority behind it, and might stand up well in court should the need arise.

But for equity and bond investing of one's own money, I'll take one practitioner with a long history of success over all the academics that might be found at U. of Chicago, MIT, and Stanford together.

Seth Klarman, one such practitioner with a long history of success quoted Wilbur Wright on the process of learning how to fly:

“There are two ways of learning how to ride a fractious horse; one is to get on him and learn by actual practice how each motion and trick may be best met; the other is to sit on a fence and watch the beast a while, and then retire to the house and at leisure figure out the best way of overcoming his jumps and kicks. The latter system is the safest; but the former, on the whole, turns out the larger proportion of good riders. It is very much the same in learning to ride a flying machine; if you are looking for perfect safety, you will do well to sit on a fence and watch the birds, but if you really wish to learn, you must mount a machine and become acquainted with its tricks by actual trial.”

So it is with investing.

Klarman goes on:

For 25 years, my firm has strived to not lose money—successfully for 24 of those 25 years—and, by investing cautiously and not losing, ample returns have been generated.

And

After 25 years in business trying to do the right thing for our clients every day, after 25 years of never using leverage and sometimes holding significant cash, we still are forced to explain ourselves because what we do—which sounds so incredibly simple—is seen as so very odd. When so many other lose their heads, speculating rather than investing, riding the market’s momentum regardless of valuation, embracing unconscionable amounts of leverage, betting that what hasn’t happened before won’t ever happen, and trusting computer models that greatly oversimplify the real world, there is constant and enormous pressure to capitulate.Clients, of course, want it both ways, too, in this what-have-you-done-for-me-lately world. They want to make lots of money when everyone else is, and to not lose money when the market goes down. Who is going to tell them that these desires are essentially in conflict, and that those who promise them the former are almost certainly not those who can deliver the latter?

Those who might be interested can read the whole piece at

http://www.retirerichblog.com/2008/02/investing-guru-seth-klarmans-talk-at.html

Ha

 

[Gotadimple]

See Random Walk

I can't remember where on this board it was stated, but it was a quote that went along the lines of, missing the top x number of up market days and you will miss out on the majority of the upswings that will make your portfolio grow.
I have also seen statistics on yty growth of mutual funds versus investors actual growth rates. The latter is less than the former due to investors buying and selling at the wrong times.

So my leaning is to get fully invested (lump sum) if I am moving money around in my portfolio. Of course I DCA'ed when I was w*rking with monthly contributions to my 401K and taxable accounts. but it was more of a 'forced DCA' since i was paid on a semi-monthly basis.

If I received an inheritance, I would most probably lump sum invest it to keep my AA in line.

Malkiel cites a study done by Charles Ellis that shows that between 1982 and 2000, if an investor missed the best 30 days of the market the return on an investment in the S&P500 would be 11.2% rather than 18%. Meaning that you can't tell when the best days of the market will be so trying to time the bottom often doesn't get the desired result.
--Rita

 

[megacorp-firee]

Malkiel cites a study done by Charles Ellis that shows that between 1982 and 2000, if an investor missed the best 30 days of the market the return on an investment in the S&P500 would be 11.2% rather than 18%. Meaning that you can't tell when the best days of the market will be so trying to time the bottom often doesn't get the desired result.
--Rita

That's the one.
It seems that the moral to the story lump sum investment then.
Because you want to be 'in' on the best days.

 

[DblDoc]

That's the one.
It seems that the moral to the story lump sum investment then.
Because you want to be 'in' on the best days.

That and the general trend of the market is upwards.

DD