Concentrating risk can pay off for savvy investors, but approach strategy with care
Financial experts are keen to tell us to put our hard-earned nest egg into a variety of assets such as stocks, bonds and real estate to get the best returns while hedging our risks but there is a powerful counter view.
When I asked DBS boss Piyush Gupta at a chat I hosted at the recent Singapore Coffee Festival what approach a person should take on his investments, I got a startlingly different answer.
He replied that it makes sense for a younger person to adopt a broadly diversified investment approach, but when that person reaches his 30s or 40s, he should take some concentrated risks in order to grow his nest egg.
"Most people don't tell you that. Most people will tell you to keep diversified," noted Mr Gupta.
"My response is to tell them to look at Warren Buffett. Warren Buffett doesn't diversify. Warren Buffett takes concentrated risks in what he believes in."
So which approach should we adopt - the conventional diversification strategy advocated by many financial experts or putting lots of our eggs in one basket as suggested by Mr Gupta? It is an interesting dilemma.
Some weeks ago this newspaper noted that the Investment Management Association of Singapore (Imas) advised retail investors that one of the most important investment decisions they have to make is not the stocks or securities they buy but how they allocate their investable funds to the various asset classes.
Yet, as Mr Buffett once observed, such diversification can put an investor into an unenviable "low hazard, low return situation".
Instead, he believes that investors should aim to make no more than 20 decisions in their life-time about what to buy or sell and that diversification is adopted by investors who do not understand what they are doing.
Many financial experts give the impression that investors in their 20s can afford to take more risks on their investments because they have youth on their side and time to make good any losses they may incur. My worry is that it is precisely the lack of investment experience that can cause a young investor to come to grief in a big way, as I have known friends who had been so badly bruised by financial mishaps in their first few years of working life that they never quite recovered, even after working half a lifetime.
Adopting Mr Buffett's approach goes against the grain of the mainstream investment strategy pioneered by Nobel laureate Harry Markowitz, who showed that diversification could reduce risk when assets are combined whose prices move in an inverse relationship with one another.
But Mr Buffett is no ordinary investor and, unlike Mr Markowitz, who is an academic, he has walked the talk, turning his company Berkshire Hathaway into one of the world's richest investment firms by taking big stakes in companies that consistently outperform the stock market by big margins.
Mr Buffett is also by no means the only exception to the rule. If we look at the portfolios of many other rich and famous investors such as Microsoft founder Bill Gates, we will find that they are also mostly concentrated on a few investments.
Going back to the past 100 years, another good example would have been the great British economist John Maynard Keynes who was able to make a remarkable comeback by refocusing his attention on individual companies and taking huge wagers on them after losing a big fortune during the 1929 Wall Street stock market crash.
As Keynes later explained: "As time goes on, I get more and more convinced that the right method in investment is to put large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes."
Still, even though Mr Buffett and Keynes are big proponents of a concentrated portfolio strategy, we will have to approach this strategy with caution.
That is because while the strategy gives seasoned investors an excellent opportunity to maximise their long-term returns through a deliberate selection of stocks, investors who lack the skill to select suitable stocks can lose their shirts if they are not careful.
And this is where I find the other part of Mr Gupta's advice useful, namely telling an investor to expand his risk appetite only after he has gained some investment experience and gathered sufficient savings to enjoy a solid financial footing.
This advice runs counter to the impression given by many financial experts that investors in their 20s can afford to take more risks on their investments because they have youth on their side and time to make good any losses they may incur.
My worry is that it is precisely the lack of investment experience that can cause a young investor to come to grief in a big way, as I have known friends who had been so badly bruised by financial mishaps in their first few years of working life that they never quite recovered, even after working half a lifetime.
There is one asset where taking a concentrated risk is familiar to many of us - buying a property.
I asked Mr Gupta his views on this during the chat.
He noted that all the great fortunes in Asia, including those made by familiar names such as Hong Kong billionaire Li Ka-shing, are made from real estate.
"In the long term, property is fantastic and property is one place in Asia where one can make a lot of money because of the high leverage," he said.
But Mr Gupta warned that if an investor buys a large property, liquidity is always a big challenge because "you cannot sell it when you want to sell it".
It all boils down to risks and rewards. Take a big loan on the property and an investor stands to make a lot of money if prices go up.
But if prices slip and the bank wants the investor to deposit more cash or securities to cover possible losses, he has to ensure that he has other assets available to meet the margin call or he will be forced to sell off the property at a loss.
However, for potential home owners, he has this advice: "If you think you can afford a two-bedroom house but with a stretch, you can do a three-bedroom, I can tell you that five to 10 years from now, you will wish that you had gone for the bigger house."
So when should we turn to diversification as an investment strategy?
I find that as I get older and more risk-averse, preserving whatever I have already squirrelled away is far more important than amassing more riches - and this is where adopting a diversified portfolio to try to preserve wealth becomes an over-riding priority.
Another great investment guru, Mr Jack Bogle, the founder of the giant fund manager Vanguard, sums up this sentiment best when he observes that the average investor doesn't want to spend his life consumed with investing - and indeed, he should not spend his life consumed with investing.
That is why a sound diversification strategy works best for those who simply want a decent return without exposing themselves to too much investment risk - or find themselves so obsessed with how their investments are performing that they are oblivious to everything else.
Sure, all of us want to make money on our investments, but as the seasons of our lives change, so should our investment habits. How we adjust our investment approach will depend on the phase of life we find ourselves in. There is a time for everything.
A version of this article appeared in the print edition of The Sunday Times on June 26, 2016, with the headline 'The case for putting lots of eggs in one basket'. Print Edition | Subscribe
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