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Thursday, October 14, 2010
Warren Buffett recommends that individual investors diversify and use low-cost index funds. But that is not what he does. It's not even close. He takes big positions. Early in his career, a few positions comprised his entire invested assets for himself and his partnerships.
What gives? Actually, it's pretty simple, I believe. Few people understand the management of risk better than Warren Buffett. What he understands, and what most people don't get, is what is glibly referred to as "firm specific risk" in the investment texts. Think of it like this: when you buy a stock, you can do a lot of research by cranking the numbers, reading the reports, analyzing the competition, and even taking into account the macroeconomic environment. But, no matter how much research you do, if you are on the outside of the company, there is still a lot you don't know.
As you get ready to click "buy," the CEO and CFO could be having lunch and talking about the phone calls they got yesterday from their two biggest customers and how they were thinking of moving to a competitor. They may be discussing that internal research report that found customers were reporting a surprising increase in company product related injuries. They may be discussing the surprising announcement that the top salesman is considering a competing offer. They may be fleshing out an idea that involves selling barges to Merrill Lynch and then buying them back after the quarter ends, to get the revenue numbers Wall Street is expecting.
This is partly what "firm specific" risk is about. And, again, if you are on the outside, it can blindside you and you have no Michael Oher to protect you.
Unless, you are on the inside and at the top levels on the inside. Even the employees of Enron didn't know what was going on.
But Warren Buffett and Charlie Munger get on the inside. They get appointed to the board. They bring their own people in, if necessary, and make it their job to minimize firm specific risk. They get to know the key people in the companies in which they invest.
Thus, his admonition to diversify is appropriate, despite his approach, because he realizes the firm specific risk the typical investor faces in buying individual companies. If you must buy individual companies, limit your buy in a single name to 5% of total assets. That's my recommendation.