For the first time I’d like to post, almost simultaneously, (simulpost?) on a subject which has facinated me for years. My purpose is merely to introduce the subject. A meatier post will follow.
Investors have been told by Wall Street to diversify since the street signs were put up on the corner of Wall and Broad in Manhattan. On the surface it seems a more than reasonable principle. After all, the only reason for its existence is to avoid losses. And who in their right mind doesn’t want to avoid losses? Indeed.
Warren Buffett and George Soros are both multi-billionaires — due solely to their ability to invest in winners. They think diversification is for those who simply don’t know what they’re doing. This is because they define risk as the result of not knowing what you’re doing. It’s ironic that most of their investments are in businesses that haven’t diversified themselves.
Here’s what Mr. Buffett had to say to his own shareholders 13 years ago:
“The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. 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.”- 1993 Chairman’s Letter to Shareholders
Mr. Soros seems to like the more direct approach:
“Diversification is for the birds.”
They both have been quoted saying:
“Risk comes from not knowing what you’re doing.”
We laugh at the thought of the coffee can full of cash buried in the backyard. But it’s not funny. The reason the old guy did that was because he simply didn’t know what else to do. He did know one thing for sure — he didn’t want to lose what he had earned so far. Fear of loss and not knowing what one is doing is what risk is all about.
Since when do fear and ignorance combine to create great investment portfolios? Mr. Buffett and Mr. Soros say never.
mike says:
If diversification is for the “fear and ignorance” crowd, into which basket should the fearless and informed crowd put all its eggs?
Real Estate?
December 20, 2006 — 9:43 am
Jeff Brown says:
Mike – Absolutely not, if you mean real estate as a default.
The point is to invest in what you know about. If you’re a whiz in currency trading that’s what you should do. If you’re an expert in precious metals, mining, hi-tech, or midwest shoe companies that specialize in pigeon-toed pregnant women – that’s what you should be investing in.
Why would anyone invest in things for which they harbor fear and ignorance? If an investor feels they don’t know enough about anything yet, they should then find something in which they’re interested – and find an expert to advise them.
This post wasn’t about real estate – which is just one of an almost infinite menu of choices for investment.
December 20, 2006 — 10:06 am
mike says:
Now I’m confused.
Are you pro-diversification or anti-diversification?
December 20, 2006 — 1:42 pm
Mark James says:
You’re point of “investing in what you know” rather than diversify just for the sake of diversification, is a good one. Knowledgeable investors tend to be “dangerous” usually quite wealthy.
I would also recommend that when one considers real estae as part of their investment portfolio, “investing with confidence” is equally important.
However, in my opinion it is very difficult to build knowledge, which leads to such confidence, when investors have little access to unbiased, factual information about real estate markets. I live in Orange County California where once can obtain horror story information from several sources about the market: foreclosures, future price declines, and at the same time receive “sunshine and all clear” messaging from local realtors and mortgage bankers.
In other words, the American layperson receives different messages depending on what the source is “selling”.
Wouldn’t it be nice for someone to come along with objective information about real estate, for a change, to help build the knowledge of investors. Call it a Realty Consumer Reports, if you want.
Lots of knowledge-rich investors is never a bad thing.
If you know of a source for “objective” information, not NAR-linked, I’d love to see it.
December 20, 2006 — 2:56 pm
Marlow says:
I don’t think there can ever be an objective source for real estate information, unless one is evaluating a REIT. Even then, “past performance is not indicative of future gain”. Even when discussing condos in the same building or identical houses in a subdivision, “objective information” is just a snapshot at that particular time, subject to change almost daily. One can “generalize” about a market, but I think those generalizations are almost worthless. Each property must be assessed individually, on its own merits. But even that is not enough because one must also know the financial objectives of the purchaser or owner of the property, what they intend to do with it, and one must have in-depth knowledge of the area where the property is located, including employment forecasts and the like. There are so many variables, that I don’t think real estate can be approached like other investments.
December 20, 2006 — 3:47 pm
Jeff Brown says:
Mike – Maybe the confusion is that I haven’t stated either way. So there’s no real confusion, you just don’t know yet. 🙂
The answer though is not as simple as that. I personally don’t diversify as a tool employed to reduce loss. So I’d say for myself only that I’m against it.
However, there are those who for whatever reason have decided not to do their homework, even to the extent of searching for an honest, experienced, and skilled advisor. For them I’d suggest that to diversify would protect them against themselves. If they’re not willing or able to either become knowledgeable or to seek out an expert, than hedging their bets makes sense.
The point Mr. Buffett and Mr. Soros makes is simple if you buy into their definition of risk: ….not knowing what you’re doing.
In general I am against diversification, if only because it’s like building a souped up race car only to attach a governor insuring it can’t exceed 100 mph. Now if the car builder is the driver and can’t drive safely over 100 mph, then the governor makes sense.
Finally it comes down to one of two approaches. The investor either knows exactly what they’re doing, or takes advice from someone who does. Otherwise they should diversify because their ignorance will no doubt come back and haunt them.
December 20, 2006 — 5:30 pm
Jeff Brown says:
Mark James – I know what you mean about NAR based. Even if the info is reliable, it’s never the entire market picture.
I lived in OC until I was 15, WAY long ago. (Went to Troy Hi.)
Mark, your comments are right on the button. I think what you really need to do IF you’re wanting to make money in RE is to put all of your effort into finding the guy who will steer you right, not just to fatten his bank account. Harsh words, but we both know I’m not talking out school. I’d interview a few ‘investment’ agents/brokers. If you find the right guy, you’ll do well.
Your idea of ‘Realty Consumer Reports’is great – it just won’t happen. There’s simply too much info. The success comes from the analytical conclusions based on the info. And that’s where the expert comes in.
I don’t know about you, but when I bought my hi-def TV, it wasn’t based solely on any research I did. The available info was just as confusing and frustrating as you described for RE. I found an expert and bought one in a day – and I’ve been a happy camper.
December 20, 2006 — 5:40 pm
Jeff Brown says:
Marlow – With the exception of your last few words, I couldn’t agree with you more. Real estate IS a difficult investment, relatively speaking, you’re right about that. But in the end expertise combined with solid research and analysis still win the day, even in real estate.
I think your main problem, and it’s very real, is that you haven’t found the expert in which you can be confident. They’re out there, you just need to keep looking.
It’s obvious you understand what’s needed to succeed. Use that in your search for an expert.
December 20, 2006 — 5:45 pm
Kaiser Sose says:
Gee Jeff, your nebulous answers were very enlightening. Thank you.
December 20, 2006 — 6:33 pm
Jeff Brown says:
You’re welcome Kaiser.
December 20, 2006 — 8:32 pm
j says:
Diversification is a general concept that must be defined or illustrated in a particular context in order to ascertain its usefulness. If you do only residential sales, are rentals diversification? If the sales market is slow, you might suffer more than if you were also able to handle rentals.
Buffet buys companies but they are not all in the same industry. Diversification or not?
If you don’t diversify, in some degree, then you must be prepared to adapt.
Thought provoking post.
December 20, 2006 — 8:43 pm
Jeff Brown says:
J – Buffett buys companies for less than HE thinks they’re worth. He maintains the current management – but only AFTER he’s personally approved them. To him, what the company makes isn’t as important as their income & growth potential. Once he decides a particular industry has potential, he doesn’t care if they make shoes, or sell real estate. And he has purchased companies in both those industries.
In his mind he’s absolutely NOT executing a strategy of diversification. It’s all businesses to him.
If your thing is real estate I think you can play semantics with the concept. For instance, if a client chooses to use relatively high leverage on some investments, he might simultaneously acquire another entirely different kind of real estate which yields much higher cash flow. I guess one could credibly call that diversification.
If by ‘preparing to adapt’ you mean change with changing times, absolutely. Analysts everywhere were very surprised when Buffett bought a shoe company. He simply changed his mind due to changing market dynamics for that industry, and specifically for that company.
I think it’s interesting that when he wanted to own a real estate brokerage on the west coast, he chose a traditional “6%” firm – Prudential California. I’m assuming his research showed that maybe the full service RE company wasn’t doomed.
Thanks for the comment, I’m always excited to hear from your end of the laptop.
December 20, 2006 — 9:19 pm
j says:
If we can play semantics as to what constitutes diversification in real estate, and I agree it is only semantics, how can we be guided by the principle? If I say sales and rentals are diversification and you say no (eg.,because it’s all real estate), the question whether diversification is a useful strategy cannot be answered. The failure to have an agreed definition renders the concept of no value as a guiding principle of action.
Maybe the guiding principle should be “Do what you know how to do best” and learn how to do something else if what you do best is no longer in demand. Maybe the abstract concept of diversification really has nothing to do with it.
Just a thought.
December 21, 2006 — 6:54 pm
Jeff Brown says:
J – I’m defining diversification, as used in the post, the same way Wall Street does. The investor buys stocks based upon limiting any potential losses. They do this by ‘balancing’ their portfolio with industries who benefit or lose value by virtue of another stock’s good or bad fortune. If one goes down, the other will rise.
The post merely states the obvious – if your main goal is to avoid losses by the acquisition of contradictive industries, then by definition you are limiting your potential for real growth.
That’s the only definition I’m applying.
So it matters WHY someone buys different real estate. If it’s to avoid losses by playing one segment AGAINST the other, they are using diversification.
Both Buffett and Soros agree that using diversification to spread risk, begs the real question.
What is risk? They say it’s “not knowing what you’re doing.”
I can only repeat what Buffett so eloquently wrote to his investors on this subject:
“The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. 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.”
I agree with you J when you speak of semantics. We both know however what the investment world means when the term is used. They’re ALL trying to spread risk and avoid loss.
Man, your comments make me work. 🙂
December 21, 2006 — 7:45 pm
Marlow says:
It’s not ME who’s looking for expert advice. I am quite confident in my assessment of the local market and invest all of my money locally. The only reason I don’t have all of my money in real estate is not because I wish to diversify. Quite the contrary. I wish to keep some capital easily accessible and also available in case another investment opportunity presents itself.
When I stated that it is difficult to approach a real estate investment like other commodities, one reason is because real estate is often self-managed, where mutual funds have fund managers and corporations have CEO’s, CFO’s and Boards of Directors, so one is relying on third-parties to make decisions that, with real estate, one would make for themselves.
Personally, I think it’s important for one to do their own research, no matter what investment vehicle one chooses, and to ultimately be responsible for ones own decisions. Asking advice is good, but if you don’t know enough about an investment to make a good decision, then perhaps that investment is not the right one.
December 21, 2006 — 8:04 pm
Jeff Brown says:
Marlow – Your points are well made, and I agree with your view.
The only point you make on which we may part ways, is in your last paragraph. You want folks to do their own research, which as a stand-alone issue can only be defined as prudent. However, it’s unlikely they’ll become as accomplished as would be required to make confident investments. You obviously know what you’re doing. They may never, for whatever reason, rise to your level of competence.
Therefore, an expert advisor would make sense for them. It becomes imperative when the poor investor doesn’t know the questions, much less the answers. And when that is true, diversification becomes almost a must. Otherwise their ignorance and subsequent lack of expertise will ultimately sabotage their efforts.
Thanks again for your very well thought out comments.
December 21, 2006 — 8:34 pm