Wednesday, January 2, 2013

Diversification vs Concentration

In my mind I have debated for most of 2012 on whether I should run a concentrated portfolio.  During the year, I have read arguments from both camps.  Off the top of my head, I think of Buffett/Berkshire and Berkowitz/Fairholme as prime examples of strong returns in concentrated portfolios. 

The argument of why you would want to put 2% of your portfolio in your 50th best idea seems very logical.  I agreed with this argument and started moving to a more concentrated portfolio.  However, during the year a few stock selections underperformed (relative to others I also found undervalued) giving me pause.  As my mind wrestled about it more, I realized that being concentrated is trying to predict the timing and catalysts in the future. 

In the past, I have noticed that I am wrong (as most people and commentators on TV) more then I am right in projecting the future.  Yet, I would continue to make projections and say to myself I know the company better I've been following it for 2 years vs 1, or something to that effect.  That being said, my forecasts did not get any better.

One well known study by Dr. Paul Slovic in which horse handicappers did no better (but became much more confident in their predictions) with more data is written about at Motley Fool (I've read at other places but can't remember the original source).   

The best real life example this year was Citigroup (C) vs Bank of America (BAC).  At the start of 2012, I felt that C was better for two reasons.  One, C was more undervalued then BAC and second, that C would come back to fair value faster.  I only bought C and was rewarded with only (I say only but really can't complain) a 40% return.  Had I also owned BAC, I would have received a 100% return.

So where I am going with this post is that if I find 50 stocks that are undervalued, I should own them all as the catalyst/timing for the future is unknown.

Source: Yahoo Finance

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