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Post of the Day
June 2, 1999

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Rule Breaker Port Folder

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Subject: Re: DIVERSIFY
Author: SatchelPaige

At risk of beating a dead horse to death, let me take a shot at this. No one at TMF (that I know of) ever took the position that diversification is a bad thing in and of itself. The Rule Breaker port IS diversified -- it owns stocks of 13 companies (yes, I know about the distribution of value among these stocks--bear with me). I think Papii has rightly pointed out that if he had put everything he had in Microsoft stock 15 years ago, he would be wildly rich, but he might still be a stupid (albeit lucky) investor. After all, no matter how much research you do, no matter how smart you are and no matter how closely you study a business, sooner or later you are going to be flat-out, dead-to-rights, ohmygoodness, e-gad, I-want-my-mommy wrong (as the Breaker Port has occasionally shown).

That's a good reason to diversify, as far as it goes. But Papii's hypothetical misses the point for the following reason: it assumes an investor's risk assessment will (and in Papii's view, emphatically SHOULD) be the same at the start of a portfolio as it is after a couple of stocks have shown you to be smack-dab, slam-dunk, bring-on-Buffett right. In fact, for most people, it probably shouldn't.

"when you come up with a couple of stocks so good that they grow to be 60+% of your portfolio, you are probably so far ahead of the market, and so far beyond what your reasonable expectations of return should be, that you can afford to take a little more risk."

There are two reasons for this. First, of course, when you come up with a couple of stocks so good that they grow to be 60+% of your portfolio, you are probably so far ahead of the market, and so far beyond what your reasonable expectations of return should be, that you can afford to take a little more risk. The fact that the Breaker is still creaming the market averages for the year despite the recent bludgeoning of the sectors in which it is most heavily invested is an apt illustration of the flexibility success gives you. Your ability to accept downside volatility increases as you reap the benefits of upside volatility.

The second and more important point reason your risk assessment should probably be different after some success is that if you have invested Foolishly, done your homework, and bought into businesses you understand and in which you believe, the resounding success of some of your companies is probably a reflection that you understood the businesses as well as you thought you did. That is, you weren't lucky, you were right. So whereas in the beginning you are making your best educated investments while accepting some risk that you could be quite wrong, after a large degree of success the likelihood that you were wrong is much, much lower. Assuming that you are continuing to monitor these businesses and that the reasons you believed in the company in the first place continue to exist, the question whether to sell these winners for the sake of further diversification is essentially asking yourself this: "Should I continue to own a successful company I know well, whose success I understand, and which has consistently rewarded my work and understanding, or should I sell it and buy into a few other companies I don't know as much about?" Essentially, in doing so, you are moving from a position in which you have demonstrated an understanding and decreased the likelihood that you are wrong and going back to the original position in which your understanding is unclear and untested. It seems to me a debatable proposition whether, under these circumstances, you are actually decreasing or increasing your risk by diversifying.

"Investing is all about playing the percentages. The better you understand a company, and the more your understanding proves out, the better the chances that your judgment about the future of a company will be correct."

Investing is all about playing the percentages. The better you understand a company, and the more your understanding proves out, the better the chances that your judgment about the future of a company will be correct. Not that this isn't already long enough, but let me use a crude sports analogy. You're a college basketball coach, starting from scratch. You scout and study hundreds of high school players and recruit the best 10 you can, because you think you understand how they can succeed. Over the next couple of years, you will learn in what ways you were right and wrong about these players when you first evaluated them, and you will have positive and negative surprises, but you will understand your team well. One or two of these players may prove to be everything you thought he was and more, by using the the skills you saw years ago to outperform the players around them. Now, in designing your team's strategy, is it riskier to build it around these players, or to reduce their playing time in favor of a few new recruits on the bench, just in case these two have a bad game? The point is that either strategy might work, but it seems the former is more likely to succeed than the latter.

Now, not everyone wants to spend the time and effort to understand businesses, and for those people, investing in a handful of companies is very risky indeed. Mutual funds (especially ones that index) are probably the best course for such investors. Nothing wrong with that. However, those who achieve results by investing in a small number of companies they understand well are not speculating at all, but playing the percentages that are strongly in their favor.

Sorry for the tome, but I got on a roll. Thanks for considering my humble opinion.