In this blogspot, I’d first like to talk about the ever-confusing fight between the types of portfolios – concentrated vs diversified – and the type of portfolio you should maintain. I will then move on to explain three types of investor archetypes (analyst, trader and actuary). The objective, at the end of this blogpost is to evaluate where our portfolios stand and where we stand vis-à-vis these investor archetypes. How does that help, you ask? Well, knowing the type of investor you are will more or less drive you towards one or the other type of portfolio which has the highest probability to maximise your wealth.
TYPES OF PORTFOLIOS
Concentrated vs Diversified
A concentrated portfolio is a portfolio which has only a few stocks in it (not more than 10-15 stocks. Ideally, it is less than 10). The idea behind this kind of portfolio is that very few investing decisions need to taken, but the returns would be pheomenal. The biggest proponent of this type of portfolio is Warren Buffett. People seem to advise that concentrated portfolio is the portfolio to maximize wealth. My opinion would be, if you are not the type of investor who can dedicate a lot of time to study ‘Investing’, it is also the kind of portfolio which might lead to a lot of losses.
A diversified portfolio is a portfolio which has a lot of stocks in it (>15, more like 30. Walter Schloss, a famous value investor has over 100 stocks). The idea behind a diversified portfolio is that it protects your portfolio even if 4-5 stock investments go south, as they form a small percentage of your total portfolio. An index fund is one of the widely used diversified portfolio investments that you can have.
TYPES OF INVESTORS
Analyst vs Trader vs Actuary
Each of these types of investors take an entirely different approach to the market, depending on his/her investment personality.
The Analyst: An investor who carefully thinks through all implications of an investment before putting even a single rupee behind a stock. This type of investor would pore through business valuations, business reports, cash flow statements, balance sheets etc. before taking a call whether to invest in a stock or not. Warren Buffett personifies this type of investor.
The Trader: An investor who invests/doesn’t invest depending on ‘feel of the market’. He trusts his gut feel and goes with the flow of the market, often spotting discrepancies which can make him profits. George Soros epitomizes this type of investor. Many investors also try to be ‘the trader’ getting in and out of markets, often with disastrous results. They don’t realize that there is a huge amount of education, discipline and competence to make money as a trader. The percentage of successful traders worldwide would ascertain to this fact.
The Actuary: Early in my investing career (which is not too long!), I thought there were only two types of investors – the analyst and the trader. However, Nassim Taleb’s book ‘Fooled by Randomness’ introduced me to this third type of investor – the actuary. This type of investor deals with probabilities, much like an insurance company. The Actuary investor is focused on the overall outcome rather than any single event. For example, the Actuary investor is willing to suffer hundreds of tiny losses while waiting for his next profitable trade which will repay his losses many times over. (Usually, this type of investor buys/sell a lot of severly-out-of-money calls/puts (which cost little) and in a significant event (like Lehman’s bankruptcy), this type of call/put (options) will have a lot of value, thereby covering all his prior loss-investments).
So, which type of investor are you? Are you none of these three? Well, Graham has an explanation.
Graham, in his investment classic ‘The Intelligent Investor’ clearly specified the differentiation between an ‘Enterprising Investor’ and a ‘Defensive Investor’ and hence the type of portfolio you need to maintain (concentrated vs diversified). An Enterprising investor is one who can spend a lot of time studying ‘Investing’ (and not the one who is young and ‘100-your age into equities’ philosophy). On the other hand, if you can’t spend a lot of time studying investing, most investors would be better off investing into index funds (the summary of Graham’s definition of a Defensive Investor’).
Therefore, if you are an Enterprising investor, try to create a concentrated portfolio (you fall under ‘the Analyst’ category). Else, stick to a diversified portfolio (index funds or diversified equity funds). Very few us have the competence and knowledge to be successful at trading/actuary. If you do decide to go on the trader/actuary path, please realize that there is a lot more education, discipline and time required to be successful in either of these two disciplines than being an ‘Analyst’.