Review & Outlook

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Rethinking Diversification: The Pearl of Great Price versus Eggs-in-Many-Baskets

1 May, 2015 by Ben O'Brien in Commentary

“Don’t put all your eggs in one basket” is perhaps the most worn out of investment cliches. It is also describes one of the central principals of modern portfolio theory, the prevailing academic theory in finance. But is it true?

Mark Twain famously said, “Put all your eggs in one basket…and then watch that basket!” Then there is the Biblical parable of the Pearl of Great Price. A merchant comes across a great treasure, a pearl of great price, and sells all his possessions to buy it. While obviously not meant primarily as financial advice, the story warns against being too tentative and hedging your bets too much. Certainly there are benefits to a certain amount of diversification, but if you come across a great investment opportunity, say a high quality stock that is undervalued, doesn’t it make sense to commit a fairly large position? Warren Buffet (in his earlier days before his company grew into a giant conglomerate) and many value investors favor a fairly concentrated portfolio.

kingdom-merchant-pearl

(Source:bibleexplained.com)

Many investors these days over-diversify. We sometimes come across portfolios of new or prospective clients with over a hundred positions, many of which are similar or overlapping. They give the appearance of diversification but actually make a portfolio more confusing and unwieldy and tend to increase fees. Moreover excessive diversification leads to delving into riskier and low-quality corners of the market, a phenomenon known as Diworseification.

Perhaps the best advice on this subject is Buffett’s idea of the punch card. Buffett once advised investors to imagine they have a punch card with twenty slots on it for their entire life. Each time they make an investment they punch a hole, and when the twenty slots are punched, you cannot invest any more. You’re stuck with your original twenty picks. If you were bound to this plan, you would probably do a lot more research and think very carefully about each investment. You would also hold positions for a lot longer and buy and sell a lot less frequently. All of these things are conducive to better long term performance.

Buffett himself seemed to follow this advice. Most of his amazing investment record comes from a handful of amazing long term investments such as Geico, Wells Fargo and Coca-Cola. Buffet first invested in Geico stock as a student in his early twenties and today, well into his eighties, he owns the whole company as part of Berkshire Hathaway. He has often said that his preferred holding period is “forever”.

The punch card analogy and the Pearl of Great Price parable are good counterbalances to the doctrine of diversification. This is part of why at O’Brien Greene we invest in high-quality individual stocks and bonds rather than a wide array of index funds and mutual funds as so many advisers do today. It is a healthy middle ground, we believe, between the risks of a highly concentrated portfolio and the folly of excessive diversification.