Investment Style Focused on Risk Diversification

Pages: 7 (2338 words) Published: November 6, 2005
Diversification, Schmiversification

Steve Smith, 23, recently out of college, has just won $15 million in the lottery. After buying a few things, he realizes that he still has quite a bit of money, and starts to look at the big picture and what he should do. After his girlfriend shoots down his dreams of buying an island paradise where he could relax and golf all day, or buying his own rocket ship, Steve is forced to think of more practical things to do with his newly acquired fortune. Unable to find a way to spend it all, Steve decides to save and invest most of his winnings. He begins searching financial magazines and the internet for the best way to build his capital.

Steve faces an issue that many investors today face—not a pessimistic girlfriend, but rather how he should invest his money. In his research, Steve has found that there is a commonly accepted investment style that is focused on diversification of risk. Risk in terms of investing is based on the possibility of losing your money. For example, stocks are higher-risk investments where government bonds are considered lower risk, because stocks are shares of ownership to a certain company, which could see hardships at any given time, while government bonds are guaranteed by the country's treasury to ensure that the investor is paid when the bond is due.

While he was doing all this searching, Steve remembered the time he was going to a Hawaiian party in college, and his searching for clothing ideas from his idol, Jimmy Buffett. In his online search, he came across some other Buffett, named Warren, who he remembers be deemed some "investment guru." Before he decides to do anything with his cash, Steve decides to see if this Warren guy is the best in his field, just like Jimmy. Come to find out, he is. Warren Buffett, currently the second richest man alive and CEO of mutual fund company Berkshire Hathaway, owes almost all of his overbearing bank account to personal investments. Buffett is not, however, a traditionalist when it comes to his style of investing; he is a man who does not believe in diversification.

The "traditional" portfolio technique, or so to call it, teaches investors to diversify their risks—simply, to have a balance of stocks, bonds, and other investments that are of varying risk. The logic is that being too heavily invested in stocks could do great harm to an investor if the stock market goes through a tough period; the same is true for less risky ventures: being too heavily invested in bonds will not cost the investor any money, but bonds do not have the potential to show the returns that stocks can. Trusted investing information companies, MorningStar and Bloomberg, both present subscribers with an education on investing. In Investing 101: Getting a Good Start with a Sound Strategy, Bloomberg says that diversification "helps preserve your portfolio's value, mainly because some investments rise while others fall." Their motivation in saying this is that unforeseeable circumstances can alter performance within and across industries. If an investor's portfolio was heavily allocated in one stock or industry, poor performance could really hurt the status of the portfolio. Similarly, being diversified can help investors to "capitalize on unforeseeable growth" of a stock or industry and thus increase their portfolio's value. MorningStar's educational series gives the same premises for diversification and goes on to say that diversification can create the most "efficient portfolio."

Warren Buffett does not agree with conventionally diversifying a portfolio, because he feels it does not truly reduce risk. He has gone so far as to say, "risk comes from not knowing what you are doing" ( Buffett's own portfolio consists mainly of the same stock holdings as his company's, Berkshire Hathaway, mutual fund portfolio. His technique is to invest in the stocks of companies that he feels will still be going...

Bibliography: Bloomberg Online. Investing 101: Lesson 2. 10 March 2004.
Investopedia. The Greatest Investors: Warren Buffett. 12 March 2004.
Mann, Bill. "The Dangerous Warren Buffett." 4 June 2003. The Motley Fool. 15 March 2004.
Morningstar Online. "Morningstar Investing Classroom Course 503: Modern Portfolio Theory section 3: Diversification and an "Efficient" Portfolio." 9 March 2004.,3163,4496,00.html.
Patton, Maynard. "Warren Buffett: The World 's Greatest Investor." 3 April 2002. The Motley Fool. 12 March 2004.
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