Many Berkshire Hathaway shareholders have a very large percentage of their net worth invested in the company. What are the risks of concentrated investments in general and Berkshire in particular?
The Capital Asset Pricing Model (CAPM) is often criticized for relying on a concept called Beta (β) which measures the correlation of the historic volatility of a security relative to the overall market. Investors are supposed to demand higher returns from securities that have a high β and lower returns from securities with a low β.
This mechanistic approach to valuation, anchored on historical volatility, is criticized as being backward looking and for not taking into account, or even examining, actual business risk which requires a deep level of analysis and understanding.
While I agree that CAPM and β have serious limitations, we should not disregard the entirety of academic finance. In particular, we should acknowledge that there are indeed two types of risk facing investors in equity securities:
Systematic risk refers to risk that is inherent in the entire market. This is risk that an owner of a fund tracking a broad-based index like the S&P 500 or the S&P Total Market Index cannot avoid through additional diversification. These risks include macroeconomic and geopolitical factors that impact nearly all businesses.
Unsystematic risk refers to risk impacting a specific business. Factors such as poor management, loss of reputation, changing consumer tastes, or any other factor that impacts only a specific business, or a small group of businesses, falls into this category. Investors can reduce unsystematic risk through diversification.
From the standpoint of academic finance, investors should not expect to be paid to bear unsystematic risk of individual securities since this risk can be diversified away. However, investors should demand higher returns from individual investments with a higher β, reflecting a higher sensitivity to the systematic risk impacting all businesses. In order to achieve returns higher than the market, an investor is forced to tolerate more volatility, as expressed by the β of his overall portfolio.
One can debate whether volatility is a good proxy for true business risk and whether the CAPM is a sensible valuation approach. I do not believe that it is, but plenty of investors disagree. However, it should be self-evident to everyone that individual companies do have unsystematic risk and that investors can in fact reduce such risks through diversification across industries or even the entire market.
All investors have the simple and easy option of owning an index fund of the entire U.S. market and there are similar index funds for foreign markets as well.
Since it is true that any investor can own the entire market through a mutual fund or exchange traded fund (ETF) at minimal cost, it follows that the owners of individual securities must expect a return greater than what is expected from the entire market. I would argue that this should be the case regardless of the β of the stock because I do not consider β to necessarily reflect true business risk. I would not be comforted by the low volatility of a low β stock to the point where I would accept lower than market returns because I do not regard volatility as representing true business risk.
As a long term investor who does not require immediate liquidity from stocks, short-term volatility is not a factor I worry about. I am indifferent to short-term volatility.
If you agree that the decision to own any individual stock requires the expectation of a return greater than a broad-based index fund, it logically follows that we should have good reasons for such an expectation. If we are indeed taking on unsystematic risk specific to an individual stock, then we should demand compensation for doing so. If we elect to have concentrated positions in individual stocks, we are effectively saying that we expect returns to be more attractive than owning an index mutual fund or ETF.
Taking a concentrated position in a single business is a risky proposition.
There are endless scenarios where things could go off-track and permanently impair the value of your investment. For proof of this fact, read the Wall Street Journal on any given day to see the wreckage of failed companies. While the overall market has advanced, albeit irregularly, over long periods of time, it is common for individual companies to disappear forever. No matter how high your net worth might be or how long it took to build, multiplying that figure by zero will make you flat broke.
The Rational Walk is a reader-supported publication.
This rest of this article is exclusively for paid subscribers. Purchasing a subscription is the best way to support my work and gain access to a growing archive of premium content. For more about the benefits of a subscription, please read the about page.
The situation gets interesting when we consider conglomerates that are comprised of business units operating across multiple industries. In such a case, we have a single company that has some level of unsystematic risk but one that is far more internally diversified than a company operating in a single industry.
In such a case, is it reasonable for an investor to own this type of company in a concentrated manner? Is it reasonable to believe that a well-run conglomerate can provide sufficient diversification? Can we justify owning it as a cornerstone of a portfolio with a particularly large allocation?