“You shall bring two of every sort into the ark.” – Genesis 6:19
Two of everything may have been the right strategy for Noah but it is not an intelligent way to build a portfolio. Similar to “justice” and “tradition”, “diversification” is a loaded word that evokes positive emotions and usually goes unchallenged. Diversification, as it is commonly practiced in finance, is counterproductive. A widely diversified portfolio is guaranteed to produce mediocre returns without necessarily providing safety, yet it is widely proclaimed to be an astute investment strategy. We believe that investing a meaningful amount of money, in a limited number of unrelated and understandable businesses, is a much safer strategy than owning small amounts of many businesses that are not fully understood.
We consider a portfolio of businesses to be diversified when their future returns are determined by unrelated factors. Portfolio diversification is not determined by the number of investments or their sector classifications. For example Lululemon and Indigo Books & Music are both considered “Consumer Discretionary” businesses yet their success is dependent on widely different factors. Conversely, businesses can be in different sectors and still be closely related – the results of a group of Alberta auto dealerships (another “Consumer Discretionary” business) selling trucks to oil patch workers is just as linked to energy prices as Imperial Oil or Shell. Most people look for safety in numbers but a portfolio of 100 speculative mining stocks is not safer than a portfolio of 14 unrelated businesses.
Another way we reduce risk is by intentionally avoiding inherently complex businesses. Regardless of research effort, investment mistakes are more common with complex businesses. For example, large banks and insurance companies are unbelievably complicated to analyze because, as was the case with Lehman Brothers before its bankruptcy, even the CEO does not always fully recognize the risks in the business. Further, learning and then following complex businesses is very time-consuming. We are not afraid of hard work but time is a scarce resource. In our experience, straightforward businesses are worth more than complicated ones because the time saved researching them can be devoted to seeking even better investment opportunities.
To summarize, a widely diversified portfolio is not necessarily safe. Safety is better provided when a portfolio owns unrelated and understandable businesses. While our approach does not provide immunity from prolonged market declines or systemic collapse, our short positions do provide some insulation.