Feb 26th, 2007 by Martin Lee
If a parent company owns a subsidiary with excellent long-term economics, is it likely for the subsidiary to be sold regardless of price?
That is the same mindset that you, as a small investor, needs to adopt when you own a small piece of an excellent company. The worst advice you can possibly get from your broker is, “You can’t get broke taking a profit”.
$40 invested in Coke in 1919 will have grown to $3277 by the end of 1938. A fresh $40 invested at the end of 1938 would have grown to $25,000 by the end of 1993.
An investment lifetime is just too hard to make hundreds of smart decisions.
Risk – Buffett’s definition
Is it riskier to hold less stocks? Risk, as Warren Buffett defines, is “the possibility of loss or injury”.
A policy of portfolio concentration may even reduce the risk as the investor would have to think even harder about a business and its economic characteristics before he invests into it.
If you are a know-something investor who is able to understand business economics and find five to ten well-priced companies that possesses long-term competitive advantage, then diversification makes no sense for you.
It simply makes no sense as to why you would want to buy more of a company that is your 20th favorite, rather than buying more of your top choices.
The real risk that an investor must assess is whether his after-tax returns from an investment will give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.
While you can’t calculate it precisely, these are the factors (in his exact words) that Warrren Buffett tells us to consider:
1) The certainty with which the long-term economic characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
4) The purchase price of the business;
5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.
Risk – Academic definition
Academics like to define risk as the volatility of a stock or a portfolio of stocks compared to a large universe of stock. So, the higher the volatility (or beta), the riskier the stock.
Isn’t it absurb that if a stock suddenly suffers a massive drop in price, it’s volatility has increased and thus it has become riskier at a lower price?
The true investor welcomes volatility. In Chapter 8 of The Intelligent Investor, Benjamin Graham introduces us to Mr Market, a person who shows up every day to buy from you or sell to you.
Whatever the price of the day, you have the option of wanting or refusing to transact with Mr Market.
Now, if the prices are extremely volatile (or riskier as defined by the books), wouldn’t that offer you a chance for you to buy at irrationally low prices once in a while?
How can that be riskier for you when you are totally free to choose whether or not to transact every day?
Despite all these, you will be able to find companies with a very strong competitive moat (like Gillette or Coke) having a volatility that is similar to other run-of-the-mill companies who possess little or no competitive edge.
Equating beta or volatility with investment risks simply makes no sense. Rather, you should be looking at the business risks as given in the five factors mentioned above.
When Diversification is Appropriate
One example when wide diversification is appropriate is when you are doing arbitrage.
If a single arbitrage transaction poses significant risk, overall risk should be reduced by making other mutually independent transactions.
Just make sure that your gain, weighted for probabilities, considerably exceeds your weighted loss, and that you can commit to a number of similar but unrelated opportunities.
This is like a roulette operator who likes to see lots of action because it is favored by probabilities, but will not accept a single, huge bet.
Another example is when an investor does not understand the economics of specific businesses. In this case, he will be better off investing in a basket of stocks through an index fund.