Eggs in a Basket

Eggs in a Basket

Diversification is what fools do to hide their mistakes. Warren Buffett According to the world’s greatest investor, Warren Buffett, and his best friend and business partner, Charlie Munger, there are really big flaws in what is being taught about investing in finance schools. In 2005 at the Berkshire Hathaway AGM, Munger commented, “modern investment theories are a crock”. The next year Munger described Modern Portfolio Theory (MPT) as “asinine”, and a year later he asserted that, “At least 50% of everything taught in finance schools is pure twaddle”.

Finance school students and investment advisors all over the world are still tested on their knowledge of MPT.  Modern Portfolio Theory was developed back in the 1950’s and one of the early collaborators was awarded a Nobel Prize for Economic Sciences.  Expert witnesses echo the findings of the academics.  Regulators use the legal precedents to assess investment suitability, so MPT and investment suitability are a bit like the difference between reading a Harlequin romance novel and actually having sex.  Two of the most successful investors in the world admit to being totally out of step with this crock of asinine twaddle.

You may find investment theories are something you want to look at a little more closely.

“Don’t put all your eggs in one basket”, is one of those home baked, apple pie clichés that we take comfort in. In the Buffett kitchen you would find that the eggs are all in one basket which is watched very closely. The difference in the number of baskets is the understanding of value. Buffett uses the term deworsification to describe the foolish behavior of loading up on sub-par businesses to hide mistakes. Rather than experiencing a single toe dipping in the waters of failure, many are inclined to stand knee deep in a potpourri of certain mediocrity.

I am a better investor because I am a businessman and a better businessman because I am an investor.

If you were to be asked, “Who is the wealthiest person you know?” chances are good that the person you name will be a business owner. The wealth of most business owners is largely attributed to one business, although there may be multiple facets to that single enterprise including other businesses within the business. The point is, much of the serious wealth we are familiar with is derived from the ownership of a single business.

There are many examples to choose from by looking at the Forbes list of the wealthiest people in the world. An obvious example is Bill Gates and Microsoft, but did you know that Warren Buffett eats his own cooking with about 98% of his wealth tied up in Berkshire Hathaway? Berkshire includes an $87 billion portfolio of publicly traded stocks where just 4 stocks account for over 60% of the basket.  Buffett is known to say, “The only thing better than owning a good business is owning more of a good business”.  Buffett has managed to accumulate 100% ownership of about 80 other outstanding businesses within Berkshire simply by focusing on value.

So what are the implications for investors? If we don’t know what we’re doing, we are well advised to get diversified. The best way to diversify is through an index because the guidance of a helper is going to cost you something. A dollar saved is a dollar earned, so any savings will compound along with the returns of the market. On the other hand, an index investor may be considered penny wise and pound foolish when compared to those who understand value and focus on a small basket of great businesses.

We don’t single out a lemming jumping off a cliff from all the others. Diversification reduces the risk of being singled out and for some advisers and their clients, preservation is about blending in. Independence is a state of mind, a willingness to think and behave apart from the others. If we are going to hire someone to assist with investing, we want someone with the courage to stand-alone; we don’t need help to roll the dice on mediocrity.

The investment managers who outperform their respective indexes are most certainly doing so because their portfolios are different from an index.  When the names of the businesses in an investment portfolio are different than those of an index and when the amounts held within those names differ from the index, those portfolios are considered to be “Active Share”.  Active Share Research proves what the greatest investors in the world have come to understand intuitively, if you want to do better than average, you have to be different.

In conclusion, the single greatest investment you will ever make is in yourself! It takes only a little more intelligence than average and the temperament of a business owner to be a successful investor. Between the humorous distractions, the clichés, and the academic theory we need to know one thing; how to assess value.  Well decorated individuals “helping” with asset allocation solutions from their ivory towers are not the answer.  Judging a book by its cover, or an asset by its name, does not ascertain value any more than a beauty contest. We will find the best opportunities are a little hairy, not as well polished as others, and the unassuming appearance is likely contributing to the underlying value.

All the very best,
David Atwood

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