“We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”

Warren Buffett wrote that statement in one of his Letters to the Shareholders of Berkshire Hathaway.  He has been sharing his investment philosophy with the co-owners of his company since 1977 in these yearly letters.  Many newcomers to retail investing find these letters on the Internet and read them to see what they can learn from the master.

Once there was an eager new investor named Igor who stumbled upon the above quote in one of Buffett’s letters.  Igor was ecstatic, because Buffett’s words confirmed what Igor was about to do – concentrate his investment dollars into what he knew best – the retail sector.  He believed he could do better investing in a few shares in an industry he knew well than he would investing in many shares.  

Igor’s grandfather got his start in retailing over 100 years ago and the entire family has remained involved in the retail business in one form or another ever since.  Igor is a manager for Woolworth’s and his first share purchase was 100 shares of WOW.

Although he knows the retail business from top to bottom, he realized he needed to develop an understanding of basic business accounting, which he did.  He also learned how to read financial statements and annual reports, especially those of retail competitors.

One day he stopped in a local tavern on his way home where he met a friend of his, whom he knew was also investing in the share market.  Igor told his friend about his first plunge into the market and announced he was looking into buying some shares of Wesfarmers.

His friend asked him what planet he was from and hadn’t he ever heard of diversification.  To manage risk, his friend told him, you should make your next purchase from a different sector.  The friend then advised him to set a goal of 20 or more shares in his portfolio, from as many different industries and sectors as possible.

But Igor knows little about other sectors and he really has no desire to learn.  He wants to build a portfolio concentrating on high quality retail shares, but he wonders if the risk of focusing on one sector will hurt him in the long run.

First, there are no guarantees that even the most highly diversified portfolio will eliminate risk.  Diversification, however, approaches “gospel truth” in much of the investing community, despite the hard evidence of poor and mediocre performance of many mutual funds.

When you think about the intent of diversification, it is almost a guarantee of mediocre performance at best.  If you balance an investment in a sector that outperforms under certain macroeconomic conditions against an investment in a sector that moves in the other direction under those conditions, what is the result?

Focused investing is a “Buffet-like” approach to investing that follows much of his philosophy with some differences.  Some proponents think of it as a hybrid approach, where diversification has its place, but is not a cornerstone of the investing approach.

A corollary of diversification is portfolio realignment.  In an ideal portfolio, investments are diversified according to an asset allocation model matching the investing preferences of the investor.  When one holding gains or loses enough to put the portfolio out of balance, realignment is needed.  There are even software programs that will review a portfolio quarterly and recommend adjustments.

The first concern of a focused investor is finding businesses with the likelihood of doing significantly better than the market over an extended period of time, regardless of what sector the business is in.  

Like Igor, the focused investor concentrates, or focuses, on sectors he or she knows.  Time is a real enemy of all retail investors, and as Buffet points out, concentrating on a limited number of shares for which you have the time, the knowledge, and the desire to follow actively may be a better way to reduce risk than to buy multiple shares of companies you have neither the time nor inclination to follow.

Focused investors also recognize the possibility of diversifying within a sector or sectors you thoroughly understand.  Igor’s retail knowledge should be enough for him to look for retailers addressing different segments of the consumer market.  There are niche retailers that deal in discount clothing and general merchandise, and retailers that deal in high-end goods.  There are niche retailers for woman’s high-end fashions, and retailers that cater to outdoor enthusiasts.

Some newcomers to share market investing are not sure where to turn to look for investment ideas.  So they scour the Internet looking for analyst recommendations and perhaps even listen to “hot tips” from friends, family, and business associates.  

Rather than rely on their own judgment, they rely on the opinions of others.  Another favorite Buffet quote with investment advice is this – Stick to your own circle of competence.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.