For those who have yet to hear about the debacle at Amaranth, here's the digest version: Amaranth Advisors is a Connecticut-based multi-strategy hedge fund that at one time had around $9 billion under management. Amaranth's staff included a young, hot-handed energy trader who, after a run of good performance, was given a great deal of latitude in trading Amaranth's energy portfolio.
Of course, for anyone who has been watching the market for natural gas lately, it hasn't exactly gone in favor of longs. After some good performance in the beginning of the year, Amaranth managed to lose $6 billion in the course of about a month. Yes, that was billion with a "b." The loss was a combination of the energy markets dropping like an Acme brand anvil and Amaranth having trouble extricating itself from a quagmire of various derivative energy positions. While this is not expected to have reverberations through the market in the way that Long-Term Capital Management did back in 1998, it certainly has turned inquisitive eyes back on hedge funds.
Although this happened in the crazy world of aggressive, highly leveraged institutional money management, I think there are certainly some lessons here even for us little guys.
Concentration on diversification
The Amaranth situation immediately reminded me of the beauty of diversification. Although Amaranth calls itself a "multi-strategy" fund, it apparently wasn't multi-strategic enough, since it managed to lose more than 50% of its total capital from movements in one market. The idea behind diversification is to distribute your money in enough different areas that a downward movement in one area won't hurt you too badly. Remember, one of the central themes of Ben Graham's investing strategy is to not lose money -- revolutionary, huh?
Of course, if you're going to diversify, you have to make sure that you're actually diversified. Maybe Amaranth thought it was diversified by having gas futures contracts in a number of different time periods, or by having swaps that covered various lengths of time. Not gonna cut it. The same goes if you try to diversify by holding SanDisk, Intel, Microsoft, and Apple -- different types of technology for sure, but a bump in the road for technology can send your whole portfolio heading for the hills. Not only are they going to be affected by a lot of the same business conditions, but in the age of ETFs, they're also likely to be bought and sold in the same baskets of stocks.
Besides the common-sense check on the diversity of your portfolio, if you want to dive in a little further, you can use correlation as a measure of your holdings' diversification. Correlation is a measure on how closely two things move in relation to each other: A correlation of one means that you've got two things moving in lockstep, while a correlation of negative one shows two things moving in opposite directions, and a correlation of zero says you have two things that are totally unrelated in their movements.
In your portfolio, the idea would be to try to get a number of stocks that have a low level of correlation, so that weakness in one given area isn't going to give you an ulcer. An example would be holding Valero Energy
You may be familiar with Warren Buffett's quote that "wide diversification is only required when investors do not understand what they are doing," or you may have picked up Phil Town's book, Rule #1, which also stresses that "diversification is for the ignorant." Despite this, there are a few reasons why I still strongly believe in diversification, chief among them that we don't all have the prowess of Warren Buffett (despite what Phil may think). Additionally, the dynamics of investing change a great deal when you're buying an entire company or taking a majority position, as Berkshire Hathaway typically does, versus buying 0.001% of the outstanding stock.
I would point out, though, that stupid diversification does little more for you than no diversification at all. In other words, if you're not doing adequate analysis on all of the stocks you're buying, instead just throwing Verizon into your portfolio because you think you need a telecom stock, you're not going to be happy with the outcome. And likewise, if you overdiversify and stack up 50 or 60 names, you're probably better off just picking up a low-cost index fund.
The beauty of simplicity
I also started pondering how nice it is to have simple investment positions, especially as an individual investor. Hedge funds and proprietary traders at Wall Street firms have every minute of each day to put an eagle eye on all the positions they have in the market. They develop and use complex risk models, and they structure multi-leg trades to grab small-margin arbitrage opportunities. And yet, there are still blow-ups like Amaranth and LTCM, and many, many more on a smaller scale that you'll never hear about.
To make market-beating returns as an individual investor, you don't need to understand how an iron butterfly option strategy works, or how to model the risk to your portfolio of crude oil moving 2%. All you need to understand is how to identify a solid business at an attractive price. Once you've done that, you can feel secure that in up markets, down markets, sideways markets, and zigzagging markets alike, your money is invested in a great vehicle. Obviously, I'm oversimplifying the Zen art of long-term investing a bit, but the discipline to watch an investment go down and still trust your analysis and hold the stock, or better yet buy more, is something that takes some practice. Finding market-beating returns without losing your hair in the process, though, is probably worth taking the time to learn.
And my overall takeaway from the Amaranth affair? Well, maybe it's not always that great to be a "pro."
For more analysis on Amaranth, check out Alex Dumortier's commentary.
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Fool contributor Matt Koppenheffer does not own shares in any of the stocks mentioned in this article, and thankfully does not hold any interest in the Amaranth Advisors fund. He does, however, encourage feedback.