This is the 3rd post in the series “How I Beat The Market”.
Buffett has been known to say “Put all your eggs in one basket and then watch that basket very carefully.” Buffett looks at the misconception of diversifying in a simple analogy. He says that if he was able to invest in different companies around his local town, then he would choose good companies that make consistent and increasing profits each year which have good management. He is not concerned with buying a diverse number of companies in different fields.
He is not concerned with how the local companies as a whole perform either. He is just interested in each company individually and if it is for sale at a bargain price. He applies this same method of ‘local’ common-sense investing to investing in the stock market.
On the other hand, most investors and advisors do the opposite. They are concerned with “diversifying” by buying companies in different fields such as (utilities, technology, industry, etc.). They are also concerned with the performance of the market as a whole and tend to buy large groups of many diverse companies that are packaged into these mutual funds which seldom beat the market average at best. It’s such a watered-down, diversified group of winners, losers, and so-so companies that you can never really hope to beat the market average.
In most cases as we’ve found out, you actually lose more than win after accounting for fees and inflation. What I’ve learned from the Buffett and Graham books is that if you diversify between a bunch of focused winners, you increase your chances of winning. If you diversify between a bunch of losers and mediocre companies, you increase your chances of losing. So when you invest in in mutual funds (mostly a group of mediocre companies), you actually increase your chances of losing by diversifying.
To give you a good analogy of when to diversify, you can learn a lot from this example made by Benjamin Graham in The Intelligent Investor about the concept of diversifying in the casino game roulette: “If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose. He has a “negative margin of safety.”” In his case diversification is foolish.
The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. But suppose the winner received $39 profit instead of $35. Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with a 0 and 00.)”
Therefore, we learn that if we invest in many diverse, so-so or loser companies, we are increasing our chances of losing. On the other hand, if we select a diverse number of good companies at bargain prices, we have the ‘house advantage’ and we increase our chances of winning.
So now we can understand why Buffett says to “Put all your eggs in one basket and then watch that basket very carefully.”
But more importantly, how does Buffett find these eggs?
Buffett’s strategy might surprise you….continue reading.
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