What Buffet's Airline Experience Teaches Us About Diversification

April 2020 - 'The Oracle of Omaha' Warren Buffet, who many widely regard as one of the best investors (if not the best investor) of all time sold out of an airline stake out at a huge loss. This action included selling all holdings in Delta Air Lines, Southwest Airlines, American Airlines Group and United Airlines Holdings. Citing the reason of a global economy in the grips of a pandemic that would change the nature of air travel for the foreseeable future.

While a story of an investment which has underperformed is hardly jaw-dropping. It does provide a timely reminder on the nature of concentration risk and the risk any investor is taking on by not having a diversified portfolio. Whenever you own one company, a certain sector of geography or an asset you have an element of 'concentration risk'. This can be seen as a good or bad thing depending on the viewpoint. The opposite of a concentrated portfolio is one which is diversified where the risk is fully spread across assets, geographies and sectors. Diversification has been called the 'only free lunch in investing' as Modern Portfolio Theory shows it can increase the probability of returns by reducing risk. Though like almost everything finance there seems to be a never-ending collection of opposing views on approach. Even Buffet himself has said:

“Diversification is a protection against ignorance, and it makes very little sense for those who know what they’re doing"

Also Buffet (April 2020 - Berkshire Hathaway AGM)

“We put what… 7 or 8 billion into it and we didn’t take anything like 7 or 8 billion and that was my mistake but it’s always a problem. There are things on the lower level of probability that happens sometimes and it happened to the airlines and I’m the one who made the decision.”

Personal Concentration and Market Diversification

I want to be clear. I am a big fan of Buffet. He is consistently stoic, open to new ideas and one of the best capital allocators of all time. There is also some very persuasive arguments for concentration risk at times however in my view this should be limited to the more controllable and personal elements of your life. For example, a business you run (not employed by, see below), your education, your family and your health. Invest heavily and specifically in that area as much as you can as you have a level of control on the outcome and the fact you are ‘all in’ in those areas is far more likely to yield better results for you financially and for your overall wellbeing.

When it comes to the discipline of investing in my view where you are putting aside money to grow your wealth. Ideally you are looking for the most optimal solution which gives you the highest probability of success and have humility with that you will not know what will be successful in advance. As you will naturally bear a larger degree of risk in the personal elements of your life. It makes sense to not have 'all your eggs in one basket' unless you have a clearly identified and persistent edge in the market which is incredibly hard to find or maintain.

A great example of how damaging over-concentration can be are those people who solely invest heavily in their own employer. This can work out well if you are lucky or be completely disastrous. As well of course with all the added bonus of the stresses and uncertainty around their employment that is connected with it.

Remember it is not the outcome we can control but our probability of achieving it.

Understanding Diversification

Asset pricing models are generally structured on the foundation of 2 of the main types of risk as

1 - 'systematic risk' which is risk that you cannot remove by diversifying. It is the risk of the market (it's beta) which is what you take on as part of expecting a positive return over time.

2 - Then the non-systematic risk or idiosyncratic risk (specific risk) which you can remove by diversification.

As we do not know the future we have to separate the facts from the story, the evidence from the anecdotes and to do that properly you have the understand:

You may achieve a good return by over-concentrating your investments but this is not a compensated risk. The market does not price in a positive return AS A RESULT of that concentration.

This is the problem with investing. The world is full of success stories and survivorship bias plays a natural part of our media. These types of stories naturally raise to the top. It can be easy to throw a story of someone who that approach has worked for but we are not living their life.

Kenneth French one of the father's of modern finance ands regarded as co-creating the most accurate model we currently have on asset pricing reminded us in a recent interview where he pained to reinstate that when evaluating investment decisions we have to remember:

"Realised return = expect return + or - unexpected return"

This sounds so obvious that it does't have to come from one of the best minds in modern finance. As Buffet found with his stake in the airlines. Concentration risk in any individual company or sector increases the impact of unexpected return. Potentially FOR you or AGAINST you. The issue for the rational investor is this 'unexpected return' is exactly that and the market does not 'price in' what can be diversified away. The market does not reward you for taking non-systematic risk specifically so in loading up on this area of risk is not expected to lead to a positive outcome. You are simply making an active call.

You also are welcoming in another risk which is almost entirely eliminated by diversifying which is, the risk of permanent capital loss or simply put, losing all your money. It's very possible a single company to fail for a multitude of reasons. However strong the company may look now, you cannot discount the unknown of future events as previous shareholders of Enron, Lehman Brothers to Thomas Cook can remind you.

If you spread your risk across the world at any point which we have meaningful data on (1900 onwards) even with markets like Russia (1917) and China (1949) going to zero. To date a globally diversified portfolio has never failed to recover.

This story is echoed throughout history with completely unexpected events occurring far more regularly than those selling stories of outperformance would like to admit. More typically, it's much more likely to be recounted the story of the 'market beating investment guru' who year after year outperformed. It's a narrative we all love to follow and think applies to us. There is something about human nature which is that we want to be that early adopter that bought into Amazon, we want to be on cusp of the new wave so we can share the story of our stock market success to our friends, probably without them asking.

A view on owning single stocks

To understand the impact of single stock selection on the probability of success we need to review the academic data. In an incredible paper covering this called 'Do stocks outperform Treasury Bills?'

(Treasury Bills are US Government Bonds and are considered a very low risk asset so we would expect low returns. In this study 1 month Treasury Bills were used for comparison).

Hendrik Bessembinder found that while the stock market does generally perform well in excess of one month Treasury Bills as the academic research and all the theory of asset pricing models would predict. A large amount of individual stocks did not. In the data researched which covered a representation US market* since 1926 they found that of the 26,000 stocks included in the study less than half generated a positive holding period of return and only 42% of the stocks had a holding period of return higher than a 1 month Treasury Bill.

When researching one of the most successful markets in history since 1926. Almost half of those individual stocks returned less than what is considered a risk free asset. The entire gain of the US stock market since 1926 is attributable to the best performing 4% of listed stocks.

(Source - Hendrik Bessembinder 2017- Department of Finance - W.P. Carey School of Business -Arizona State University *CRSP monthly stock return database)

The take away from the research from both papers is clear and the technical way to say this is:

There is a positive skewness in the cross section distribution of stock returns which generates the majority of returns in a given stock market.

Or simply put:

The majority of the 'heavy lifting' which generates the positive return of stock market is done by a relatively small amount of stocks and we won't know which stocks they are in advance.

If good investment returns are considered ‘the needle.’ You are effectively looking at a choice of trying to pick the needle in the haystack, or the haystack itself.

A global view

At time of writing Apple Inc's market cap has just exceed that of the entire FTSE100. Apple as a single company is priced as being more valuable than the 100 of the largest companies in the UK market. Whether that will be a good or bad things for the future fortunes of either is anyone's guess but a quick look back at the data reinforces however over time there is considerable shifts to the relative size of world stock markets.

Source - Credit Suisse Global Returns Yearbook 2020

This concept isn't going anywhere anytime soon. All you need to do is see the impact of China's growth over the past 10 years to see this. The key thing is that we don't know in advance exactly who will be the winners and losers on a global scale but sufficient global diversification means that we don't necessarily have to. We just have to spread our risk and take part of what is expected to be the overall advance of the market. Not that of an individual company, sector or even country.

Lessons from the best

The intention is not to drive you to change your investing approach to one where you take no joy out of the process. If you enjoy looking through company statements, sitting in on annual meetings and keeping constant tabs on developments in that's company's sector. More power to you. You may achieve success through this and it may be through skills or perhaps through adherence. The best plan is generally the one you stick to.

If however you don't have time to become a Professor of Finance and it isn't a pastime that you genuinely enjoy pursuing then you need to ask yourself. Is it worth the endeavour trying uncover something that financial theory states is generally already priced in and also increases your risk of permanent capital loss?

Remember, to outperform the market you have to not only be right about the success of one company but also more so than what is already been baked into the price. As well as the opportunity cost of your time pursuing other things.

The approach is up to you but in a world of investing contradictions as even the most famous and experienced investor has found recently. Things can and do go against you when you diverge from the research and on that note, just in case you weren't confused enough I'll leave the last words on investing for Warren:

IMPORTANT DISCLOSURE

Any views stated here are individual and should never be considered as advice. Investment involves risks. The investment return and principal value of an investment may fluctuate so that an investor's portfolio, when redeemed, may be worth more or less than their original value. Past performance is no guarantee of future results.

The information provided in this article has been compiled from sources believed to be reliable and current, but accuracy should be placed in the context of the underlying assumptions.

All articles are being provided for informational purposes only and should not be considered to be investment or tax advice. No investment decisions should be made solely based on the information in any of these videos or blog posts.

Image credit:

Photo by Nathan Hobbs on Unsplash

Warren Buffet image used on personal licence and edits on image used on ‘fair use’ principles. Both image sources can be removed upon request.