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If Warren Buffett doesn't diversify, why should you?
Citywire's Smart Investor says you only need shares and bonds for a well-balanced portfolio.
by Smart Investor on Dec 10, 2012 at 08:01
Followers of the most successful investor of all-time, Warren Buffett, may already know his thoughts on diversification. For those of you who do not, his views are quite simple: he doesn’t believe in it.
Of course, all of the textbooks and all of the advisers will tell you that he is wrong. Indeed, his mentor, Benjamin Graham, will tell you the same thing. However, maybe Buffett has a point; maybe diversification is at least overrated?
Diversification can take two main forms for the private investor who runs their own portfolio: diversifying among asset classes and diversifying within each asset class. For example, you may hold a mixture of shares, bonds and commodities in your portfolio (which is diversification among asset classes) and then hold a number of different companies within stocks and bonds (which is diversification within asset classes).
The main reason used to justify diversification is that it spreads risk. In other words, if your portfolio contains only shares and the stock market falls, then you will sustain large losses. Whereas if you had some government bonds and other assets in your portfolio (in addition to the shares) your losses may have been smaller.
The idea of spreading risk extends to diversification within asset classes, with a portfolio of 20 stocks being less risky than a portfolio of 2 stocks since if one company goes bust it will halve the latter and make a smaller dent in the former.
Risks allayed, what about rewards?
However, if the world’s richest investor does not diversify, why should you?
Sure, it may reduce risk but risk is only one side of the equation – reward is the other and diversification, whilst it undoubtedly reduces risk and volatility within a portfolio, can also reduce your reward.
This is especially obvious when investing in shares or funds. The long term performance of shares is generally accepted to beat other asset classes. This is open to some debate, but is generally accepted as fact in the investment community. Why, then, would you invest in assets which are not generally viewed as delivering the same or better level of return? Surely that is counter-intuitive?
To an extent, it is. This is because many major asset classes are closely correlated, since they rely upon the performance of the economy. Shares, higher yield corporate bonds and property are examples of assets which tend to perform better during periods of economic growth and worse during economic downturns. Why, then, would you invest in corporate bonds or property if they suffer when shares suffer and offer a lower long term return?
One up, one down
Surely you should be seeking out assets which are negatively correlated; i.e. when one goes down, the other goes up and vice versa. That way, you can continually buy low and sell high.
Going back to Benjamin Graham, this is exactly what he recommends: a portfolio made up of shares and bonds only, with a minimum of 25% in both assets and a maximum of 75% in one asset, gradually moving between the two as a see-saw does depending on where value is being offered by the market.
So, when shares are cheap you should move to 75% shares and 25% government bonds (gilts). When shares are expensive and government bonds offer high single digit gross redemption yields, move the other way. Of course, this will not be a sudden movement but a gradual one, taking advantage of cost averaging and low commission costs via aggregated orders.
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