THE legendary Warren Buffett, who is among the greatest investors of our time, is an inspiration to people all around the world who aim to be wealthy. In a nutshell, he has successfully compounded his investments by about 20% annually over the past 55 years, essentially by managing a concentrated portfolio.
Anyone who had invested RM100,000 with Buffett when he started his operations in 1964 would have pocketed RM630mil today. That’s 513,055% of the original investment a simple indication of how successful Buffett is as an investor.
His fame as the CEO and chairman of Berkshire Hathaway has earned him the nickname of “the Sage of Omaha”, after the city where the company is headquartered. Buffett’s investment acumen has made the company the eight largest in the world, with annual revenue of US$162bil. Today, a single share in Berkshire Hathaway is worth US$153,200. Given his phenomenal track record, it is no surprise that the company’s annual meeting draws an amazing 27,000 people from all over the world.
Naturally, investors hang on to his every word for guidance on how to grow their wealth. Some of his most famous investment quotes include:
“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”
“Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
“Only when you combine sound intellect with emotional discipline do you get rational behaviour.”
Buffett is famous for promoting his belief that a concentration of assets is the key to building their value. He is often quoted as saying that “diversification is protection against ignorance”.
Buffett remarks, “The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk.”
To further this point, he frequently refers to diversification as “diworsification”, a term coined by Peter Lynch, another great value investor who, like Buffett, advocates the importance of a concentrated investment.
A study in 2007 showed that, over the past 25 years, Buffett’s top five holdings have comprised 73% of his total investment portfolio. Explaining this strategy in relation to the huge Long Term Capital Management (LTCM) hedge fund, which he had offered to buy over at one point, Buffett stated: “Later in 1998, LTCM was in trouble. With the spread between the on-the-run (benchmark) versus off-the-run (non-benchmark) 30-year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.”
The LTCM saga, however, is a story for another day. As it turned out, the distressed fund was rescued by a consortium of lenders invited by the Federal Reserve of New York to prevent serious fallout to financial markets.
What is relevant here is that since Buffett’s formula has worked so successfully for him over the past 55 years, shouldn’t everyone be listening to his wisdom? If he did so well with concentration, shouldn’t everyone concentrate their investment as well?
How diversified is your investment portfolio? Doesn’t it seem odd that your comparatively modest investment portfolio is more diversified than Warren Buffet’s multi-billion dollar portfolio?
The answer is that there is an important difference between Buffett and the ordinary investor that we ignore at our peril.
To achieve financial success, we need to focus on two activities money creation and money optimisation. Let us look at these two aspects of managing wealth a little closer.
When do we apply Buffett’s “concentration” principle? Basically, we should focus our efforts on our full-time business and profession when we want to create and maximise our wealth. Bill Gates, for example, grew his wealth by focusing his money, effort and resources into the IT industry. This strategy has put him at the top of the world’s rich list. Similarly, many successful entrepreneurs and top professionals in Malaysia are putting that principle into practice.
However, concentration comes with high risk. The case of Adolf Merckle, who was among Forbes’ list of 100 richest people comes to mind. In January 2009, Merckle committed suicide after his RM32bil financial empire unravelled following a bad bet against Volkswagen shares. Merckle had short-sold the car maker’s shares, speculating that its price would fall, but was caught out when Porsche took over the company and sent its stock soaring. This should serve as a caution that seeking fast and high returns on a concentrated investment exposes us to higher risk.
Now, let us consider when to apply the diversification principle. We should diversify when we want to optimise the wealth that we have created. This is to ensure that our assets are exposed to minimum risk. The purpose is to preserve our wealth against multiple risk factors.
Say we have worked hard for many years to build our business, and even successfully listed the company on Bursa Malaysia. Subsequently, we should transfer that wealth out into other assets, so that if conditions change, we are not affected.
Bill Gates has adopted a similar principle. After building his fortune in the IT industry, he told the chief investment officer of his personal wealth to put his money into any business anywhere in the world except in the IT industry. In that way, his personal wealth is protected from the risks of the sector in which his business operates.
Concentration may be great for some, but it’s not for everyone. Buffett can adopt a concentrated portfolio as he has the privilege of spending every single hour of every day managing his investments. Basically, investing is his full time business and money creation activities.
To quote Buffett once again: “If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.”
It would be a financial minefield for middle-class Malaysians to concentrate their investments, as many do not have the privilege of time that Buffett has. On top of that, he has vast expertise and experience in investment, which was not gained overnight. Buffett started his investment foray a half-century ago, while the middle class do not even have the time to gain enough knowledge about investing, leave alone actually doing so.
So, before you apply any strategy in your share & stock investing In Malaysia, make sure that you understand the investment strategy properly and completely. Know your own circumstances too. Are you investing for money creation or money optimisation? What is your risk tolerance, target return, time horizon? What are your financial goals? If necessary, discuss your plan with an independent financial adviser.
Always remember, a little knowledge could be dangerous.
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