Should you spread your investments around or focus on your favourites?
Some 2,200 years ago, the Chinese General Xiang Yu crossed the Yangtze River with an army of 20,000 men, aiming to defeat the rival Qin dynasty.
Having landed, Xiang ordered his men to prepare three days worth of food rations. Once they had done this he had their boats set on fire and destroyed their cooking equipment! By doing this Xiang gave his army two options; win or die.
Some choice you might say, but it worked! They swiftly routed the much larger Qin army and after his final victory Xiang was crowned Emperor of China. Of course had they lost then Xiang would probably have been killed by his own men for his folly!
But what does this tale have to do with investing? Well, it turns out that some investors follow a similar policy to Xiang, albeit one with lesser stakes. These investors deliberately restrict their options by focusing upon only a few investments, or even just the one ("betting the farm"), because this offers the possibility of superior returns (when it works).
Warren Buffett has an interesting idea which causes investors to concentrate their firepower. He suggests that investors should assume that they have been given a punch card with twenty slots and every time they make an investment one of their slots is used. When the last slot is punched that's it, no more investing for you.
The concept of an investment punch card is intended to concentrate the mind. But anyone who follows it literally will find that it forces them to hold just a few investments at any given time. Wonderful if it works, but a nightmare if it goes wrong.
Why we concentrate
Owning a very concentrated portfolio, one which contains a small number of investments, is a strategy employed by investors who want to increase their potential returns. But investors who do this must also be prepared to accept the risk of major losses.
The extreme example, like Xiang and his army, is to follow Mark Twain's Pudd'nhead Wilson and put all of your eggs in just the one basket. It's brilliant if it works, as anyone who put all of their money in Rockhopper Exploration (LSE: RKH) at the start of 2010 can tell you (they've made more than 500% on the year even after a heavy fall this Wednesday morning).
But had they put everything into a company which collapsed then they would have lost the lot! It's a dangerous strategy.
Many investors used to hold concentrated portfolios which mostly contained bank shares. Now put yourself in the shoes of such an investor whose portfolio in early 2007 consisted of four shares; HBOS, Royal Bank of Scotland (LSE: RBS), Bradford and Bingley and Northern Rock. How would you now feel having lost more than 95% of your total worth?
The second part of Twain's dictum is "… and watch that basket." If you concentrate to this extent you must keep a very close eye on your investment basket. Most of us are not prepared to take such a risk so we instead choose to hold many different investments.
Why we diversify
You diversify by splitting your wealth between different classes of asset, as well as within each asset class. The textbook diversified portfolio contains a mixture of shares, fixed-interest investments, index-linked investments, cash, commercial property, residential property, antiques, land, gold, jewellery, commodities and other things that can be bought and sold.
The intention of diversifying is that when the value of one asset class is badly hit your overall losses will be relatively small. Furthermore many events which produce falls in the value of some asset classes will also cause the value of other asset classes to rise.
A good example of this was seen at the height of the banking crisis in late 2008; investors' shares took a hammering but their holdings of government bonds rose in value as panic-stricken investors flocked to buy bonds.
Diversification is a defensive strategy; you reduce your risks by holding investments whose performances are not closely correlated with each other. For example, the prices of long-term bonds and shares have tended to move in different directions, which is why one of the major asset allocation decisions most investors face is what proportion to split between shares and bonds.
A few more points
A strong argument in favour of concentrating your portfolio, at least to some extent, comes from Peter Lynch who coined the term "diworsification." Lynch said that diworsifying occurs when investors have diversified their portfolios to such an extent that most of their investments have negative correlations with each other. So when one asset class goes up, another falls and the net result is that the portfolio tends to stagnate.
Watch that you don't fall into a diworsification trap, if only because monitoring several hundred investments is a lot of work!
Also keep an eye on your shareholdings; some companies become over-dependent on a major customer and will suffer badly when that customer decides to go somewhere else. Farmers know all about this problem as many of them have been clobbered by the supermarkets in recent years.
One of the best examples of this was seen ten years ago when Marks & Spencer (LSE: MKS) stopped buying clothes from William Baird. M&S was responsible for over a third of Baird's sales and the effect was pretty devastating.
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