Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [11]
As we conversed,Warren seemed to find new knickknacks to place on a memory mantelpiece. Aristotle believed a trained memory is essential for developing logical thought processes. Warren does not rely on finance nursery rhymes like “diversification reduces risk,” in fact, he often rejects them in favor of logic. Renowned professors like Yale’s Benoit Mandelbrot urge investors to broadly diversify as a way around the fear and greed driven fluctuations of what Benjamin Graham called the manic depressive “Mr. Market.”5 Mandelbrot, who popularized fractals, seems resigned: “It is, in my view, premature to be hoping for serious gains from fractal finance.There is still too much we do not know.”6 Mandelbrot is correct about fractal finance, but he might be surprised to learn that Warren Buffett is not a big fan of diversification for the sake of it. Diversification does not guarantee that you will not lose money; it only makes it less likely you will lose it all at once.
Warren is a fan of index funds for people who want low fees, want to invest in the market, and do not have the time or inclination to learn about companies. But diversification simply for the sake of it is false prudence. By ignoring discrete risks, diversification can unnecessarily add risk to an investor’s portfolio. Like all defensive strategies, diversification is most effective if you understand what you are defending against. Warren advocates diversifying only into assets you understand well.
Highly skilled managers diversify less and perform better than less skilled managers. Warren seeks investments with a long-term competitive advantage in a stable industry run by decision makers with a “here-today, here-forever” outlook. Warren does not discriminate between value companies and growth companies; he looks for businesses that throw off tremendous cash flows and have high revenue growth potential. Warren is delighted when the market hands him a good company at a cheap price, but he is content to buy a good company at a fair price.
At the time we met, Warren trounced both “growth” and “value” managers. According to Sandford C. Bernstein, Inc.’s mutual fund performance results from 1969 to 2004, value managers outperformed growth managers. Berkshire Hathaway handily beat both growth and value managers. For example, Berkshire Hathaway’s annualized return for the period 1969-2004 was 24.1 percent versus only 12.3 percent for the value managers; it beat value managers by 11.8 percent on an annualized basis. Any way one sliced the time periods, Berkshire Hathaway’s performance far exceeded the mutual funds (Table 2.1).
Table 2.1 Total Return BRKA vs. Growth and Value Managers
Source: Sanford C. Bernstein, Inc., Strategic and Quantitative Research Grp.;Tavakoli Structured Finance,Yahoo! Finance.
The Yale Endowment, headed by David Swensen, might be a better comparison.Yale is renowned for its investment acumen, ranking in the top one percent of large institutional investors. In the 10-year period ending June 30, 2003,Yale’s private equity investments earned 36 percent annually, chiefly due to its venture capital investments. But the overall Yale portfolio earned 16.0 percent, and during the same 10-year period Berkshire Hathaway returned 16.8 percent. (From June 20, 2003 to June 29, 2007, Yale had annualized returns of 23 percent; Berkshire Hathaway had annualized returns of 10.8 percent for the same time period.) The average individual investor does not have access to Yale’s tax-exempt endowment but can purchase Berkshire Hathaway’s tax-efficient equity on the open market. Moreover,Yale is considerably smaller than Berkshire Hathaway. Berkshire