Diversification is a risk reduction strategy illustrated in the idiom “don’t put all your eggs in one basket.” This implies we risk everything by relying on one asset, firm, idea or approach. Of course, Mark Twain, in 1894, wrote, “the wise man saith, “Put all your eggs in the one basket and watch that basket!”
In truth, anyone seeking to “outperform” the market needs to concentrate their investments in some way that yields sufficient excess gains to account for the costs and effort required to generate those gains. Warren Buffett often compares his approach of large bets on businesses he understands with investing in a portfolio. He notes how Berkshire Hathaway created most of their money from a small group of excellent businesses. When speaking to students, Buffett says, with his “20-slot rule”, he could:
“…improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches — representing all the investments that you got to make in a lifetime…under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”
In practice, we as individuals “punch slots” and concentrate our efforts through investing in our careers and skills, securing promotions and bonuses, building up our businesses and allocating excess funds to pay down debt or grow long-term positions in low cost, heavily diversified index funds. However, asset managers have a different context when diversifying the investment portfolios under their management.
Three mistakes and misunderstandings we observe in efforts to diversify investment portfolios that may or may not hold timberland include:
- Overdiversification. Effort spent increasing a position from 1.0% to 1.5% of a portfolio could be better spent sleeping, reading or cleaning gutters. Most portfolio diversification can be obtained by including just a few assets in a portfolio. Progressively adding one more asset has a diminishing effect on risk. In Applied Forest Finance and Wood Flows & Cash Flows events, we talk to the marginal benefits and risk management implications (up and down) of diversification. For a stock portfolio, for example, most diversification is captured with 8 to 10 stocks. And for timberland portfolios, most diversification occurs with 3 or 4 tracts that meet a specific set of criteria related, primarily, to their location relative to each other.
- Obfuscation. Complicated portfolios lack clarity, transparency and, often, effective controls. If the investment strategy of the portfolio is hard to explain or understand, then it will also be hard to manage and implement. In forestry, for example, many investors or asset managers address this by employing simple strategies that focus on a specific geography or specie or age class. In turn, these focused strategies concentrate effort and mitigate risk.
- Overhead. Fees matter. Index fund pioneer and Vanguard founder, John Bogle, said, “You get what you don’t pay for.” His message: minimize fees. Building teams of active managers adds overhead while reducing the potential impact, positive or negative, of any specific strategy.