Below is Part 3 of PM Jar’s interview with Howard Marks, the co-founder and chairman of Oaktree Capital Management, on portfolio management.



Part 3: The Intertwining Debate of Diversification and Concentration

“Diversification in itself does not add or subtract value, it only affects the probabilities.”

PM Jar: During times when you are overwhelmed by opportunities, such as in late 2008, do you diversify your portfolio and buy everything that looks attractive, or do you concentrate and buy the one or two most compelling things?

Marks: We’re diversifiers because we’re conservative investors, and one of the hallmarks of conservatism is diversification. The more you bet in each situation, the more you make if you’re right, and the more you lose if you’re wrong. For the diversifier, his highs are less high and his lows are less low. We tend to diversify.

As you describe, in late 2008, when there were a million bargains around, we tended to have a very diverse portfolio. In another period, like 2006, when there aren’t too many bargains around, we may have a more concentrated portfolio (because we can’t find that many attractive things). But our preference is to have a diversified portfolio.

PM Jar: Does your diversification-concentration preference change depending on where you think the pendulum is located across market cycles?

Marks: Our preference doesn’t change. Our preference is to be diversified. However, the ability to have a highly diversified portfolio of attractive securities changes from time to time, and we have to change with it. If you insist on having a highly diversified portfolio in periods when there aren’t many bargains around, then by definition, you have to buy non-bargains, or very risky things.

PM Jar: In 2008, a number of fund managers kept concentrated portfolios of “cheap” names, but concentration did not protect them during the crisis.

Marks: You can’t make any generalizations from 2008. It was an extreme outlier in terms of how bad things got. I wrote a memo in that period, in which I used the section heading “How Bad Is Bad?” People often say, “We want to be prepared for the worst case.” But how bad is the worst case?

2008 was worse than anybody’s worst case. Diversification didn’t work. It didn’t matter whether you were diversified between stocks or bonds, among stocks, or among bonds – everything got hurt. The only things that worked were Treasurys, gold and cash.

You have to learn lessons from history, but you have to learn the right lessons. The lesson can’t be that we are only going to have a portfolio that can withstand a re-run of 2008, because then you could not have much of a portfolio.

Correlation is a funny thing. In theory, every security has a risk and a return. Even if you’re a genius and can quantify the risk and return for every security, you wouldn’t necessarily form a portfolio composed of all the securities that had the best ratio of return to risk, because you have to consider correlation. If something happens in the economy, do they all perform the same or do they perform differently? If you buy 100 securities and they all respond the same way to a given change in the environment, then you don’t have any diversification. But if you have 50 securities which perform differently in response to a given change in the environment, then you do have diversification. It’s not the number of things you own, it’s whether they perform differently. A skillful investor anticipates, understands, and senses correlation.

These managers you mentioned knew their securities, but they obviously did not accurately estimate how bad things could get in the crisis. As you know from reading my book, one of my favorite adages is: “Never forget the six-foot tall man who drowned crossing the stream that was 5-feet deep on average.” So those guys may have been tall but they didn’t make it across. And if not, then was there anything that they should have done to enable them to get across? But it’s very, very hard to second guess behavior in 2008 because it’s very hard to have a portfolio that would do okay in 2008.

PM Jar: The second to last chapter of your book is titled “Adding Value,” and in it you describe that in order to add value, an investor has to build a portfolio that has asymmetry on the upside versus downside. If you run a concentrated portfolio in a more expensive environment, is that a way to lower downside exposure?

Marks: Concentration is a source of safety only if you have superior insight into what you are doing. If you have no insight, or inferior insight, then concentration is a source of risk. Diversification in itself does not add or subtract value, it only affects the probabilities. Concentration is better if you have superior insight, and diversification is better if you have limited insight. Neither one is better than the other per se. These things are intertwined.

Continue Reading — Part 4 of 5: The Art of Transforming Symmetry into Asymmetry