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Warren Buffett, Chairman and CEO of Berkshire Hathaway, is perhaps the greatest investor of our time, if not ever.  At buffettologist.com, we have been studying, practicing, and learning from the teachings of the Oracle of Omaha for years.  As such, we have created this blog to share our insights on Mr. Buffett, other Buffett disciples, and value investing.

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Monday, July 20, 2009

What is Asset Allocation?

There is an old saying, that if you do the little things right, the big things will take care of themselves.  And in almost every case, from a football team driving towards a championship season, to a fledgling business trying to gain customers, does this maxim usually prove correct.  Then why, one might ask, in the investment world do most professionals focus most of their time on trying to make the big decisions?

Several years ago, there was a bunch of research done that suggested that most folks’ investment returns were primarily determined by which assets or sectors they allocated a percentage of their capital to.  And like the light of a match, people started trying to determine what their “optimal asset allocation framework” should be.  They posited that maybe it should be 60% stocks and 40% bonds, or 50% towards healthcare companies and 50% towards commodities, or 20% in cash and 80% in real estate, and well you get the idea, this list goes on.   The thinking was, that if you get the exact percentage of each asset class right, it wouldn’t matter so much what the individual investments actually are.

And while I’d probably agree that methodology of this research was likely done with solid empirical backing, I’d argue that the conclusions drawn from it were entirely backward.  To me, at least, it seems impossible to determine the exact percentage of one’s portfolio that should be invested in a particular asset class, no matter how much data analysis one does.  Nor is it feasible to determine in which asset class, in fact, the money should be invested.

The problem was that most folks’ conclusions were that the most important thing to do was to make big top down decisions about how they wanted to invest their money.  I’d argue, on the other hand, that this asset allocation research should instead be interpreted as the outcome of continuously searching for reasonably priced individual investments.  And if one starts finding good investments (which can tend to cluster in the same assets or sectors), their portfolio will exhibit a certain “asset allocation framework,” but it will be arrived at by finding good investments, rather than drawing a line in the sand and deciding how the assets should be allocated.

The difference in these interpretations is dramatic.  One viewpoint (the top down one) compels action.  The other, (the outcome one) educates the investor about what her portfolio actually looks like.  And to me, at least, education almost always trumps action.

The bigger implication of this “outcome” viewpoint, though, is that the individual investments do matter.  There are thousands of stocks and thousands of bonds, and by just saying that you have 60% of one basket and 40% of another, says nothing about the quality of your portfolio.  If, on the other hand, one finds good and understandable investments at reasonable prices, that investor will do just fine, regardless how someone else labels their investments. Just like the old saying above implies, by focusing on the individual investments in your portfolio, your larger “asset allocation framework” will eventually take care of itself.

I welcome dialogue with my readers, so please send me any questions and comments you have.  Also, if you haven’t already done so, please be sure to sign-up for my free email alerts from buffettologist.com by emailing me at Justin@buffettologist.com.

Justin

Copyright © 2009 Buffettologist.com


The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business.  This content is intended solely for the entertainment of the reader, and the author.

11:23 am edt | link 

Friday, July 3, 2009

Does Diversification Make Sense?

If you were to go to a restaurant today and order some food, would you order one of everything on the menu, or would you just order a few of the things you really knew that you liked?  Chances are—and I might be taking a big leap here—that you would know what you liked for whatever reason (taste, healthiness, price), and would order just a few of those things, rather than thinking you had to have one of everything on the menu.  Maybe I’m in the minority here, but that course of action seems to make the most sense to me.

Yet in the investment world, most folks seem to be encouraged to have one of everything off of the proverbial financial menus that larger financial firms offer.  The reason typically given for promoting this type of behavior, is that the more investment products one has, the more that person’s portfolio is diversified.  This assumes, of course, that diversification is something that should be universally desired among all investors.  But does this really make sense?

At first blush, diversification seems like a good idea.  In theory, when one investment declines in value, another less correlated investment should tend to rise in value, leaving the investor’s portfolio somewhat unchanged.  While this should generally make folks feel better about their portfolios, to me at least, it doesn’t make a lot of sense from an investment perspective.  For example, if the aim of a diversified portfolio—a likely moving definition—is to protect investors on the downside, the natural corollary to this, is that investors are giving up the potential for gains as well.  And if an unchanged portfolio is the typical outcome of a diversified portfolio, why pay the huge fees of various investment products sold by larger firms?  Why not just hold cash?

But I think that in some cases that this “diversification” mantra can be even worse than only holding cash.  How many of your portfolios were supposed to be fully diversified over the last year, and even so, they are now worth 40-50% less than they were two years ago?  Not much of a ringing endorsement, if you ask me.  In times of crisis—just when diversification is needed most—all the correlations of the different investment products tend to converge to one, thereby reducing an investor’s downside protection.  In this case, folks would have even been better off holding cash, and what’s more, they wouldn’t have had to pay all those fees to their “financial advisors”—a euphemism for sales person--for their various investment products.

A couple of years ago at the Berkshire Hathaway (BRK-A) annual meeting, an attendee asked Berkshire Vice-Chairman Charlie Munger a question about the merits of diversification in investing, and Munger sagely advised, “The whole secret of investment is to find places where its safe and wise not to diversify.”

If one thinks about this, what Munger is actually saying is that the notion of diversification--as most “financial advisors” interpret it--is nothing but hogwash.  Rather, the advice he is imparting in the first part of that statement is that investors should search for a few businesses or securities where the margin of safety is so great—or said another way, the price is so low—that it is highly unlikely for an investor to lose money.  Downside protection, in this case, is not contingent on a group of esoteric correlations, but rather by the price you pay for a particular investment.

In the “wise” part of the statement, Munger is implying that if you can find a few investments with upside potential, where you understand the business or security so well that you have an edge over others, it would behoove an investor to make that a larger investment in their portfolio, as long as the price paid for the investment has a large enough margin of safety.

And, in my opinion, this approach to investing espoused by Munger is actually better than even diversification in theory, as it gives investors both downside protection as well as the potential for huge upside for their portfolio.

My best wishes to you and yours for a happy and safe Fourth of July holiday.

I welcome dialogue with my readers, so please send me any questions and comments you have.  Also, if you haven’t already done so, please be sure to sign-up for my free email alerts from buffettologist.com by emailing me at Justin@buffettologist.com.

Justin

Copyright © 2009 Buffettologist.com


The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business.  This content is intended solely for the entertainment of the reader, and the author

10:14 am edt | link 


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Justin Fuller, CFA provides his market and investment commentary on this website.  Justin has been following and studying Warren Buffett, Berkshire Hathaway, and other leading value investors for years.  If you'd like to be put on his distribution list, or to send him any questions or comments, he can be reached at:  justin@buffettologist.com.

 



The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way.  This content is intended solely for the entertainment of the reader, and the author.