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Today, I want to remind you of the great importance of having a well-diversified portfolio because, over the past few years, I’ve been watching with concern as some very high-profile, star investment managers have made large and highly publicized bets—in some cases, “betting the ranch”—by putting a large chunk of their investors’ monies into just a few stocks and talking up their positions on mainstream media, causing much volatility in the shares they’ve invested in. These masters of the universe command Cadillac-style fees and, in return, investors expect turbo-charged performance.
But by taking overly concentrated positions, these investment managers are also violating that very basic rule of investing: Never wager excessively on one stock because if that stock tanks, you lose big time. One of the major money mistakes we should all take notes from.
As an example, I’m sure many of you are aware of the much-publicized assault on HerbaLife by Bill Ackman, who made a billion-dollar bet against the company in December 2012. Ackman shorted HerbaLife (which is a risky and fairly rare phenomenon) in which an investor not only bets that a stock will go down but publicly announces that he has done so and explains why. Ackman accused HerbaLife of running a Ponzi scheme and bilking innocent franchisees. But HerbaLife fought back, saying its business was legitimate, and, three years later, HerbaLife shares are at about the $60 level, two-times higher than the $30 level at which Bill Ackman’s short position will make him a profit.
Another great example of just how wrong a concentrated bet can go is playing out right now on Wall Street. And Bill Ackman’s in on this one, too. He, along with several of Wall Street’s star investors bet a lot of money—billions of dollars—on a Canadian drug company called Valeant and made bold claims that the company was undervalued. But, unfortunately for them and their investors, Valeant stock plummeted from over $260 a share in August 2015 to about $32 this week, a drop of nearly 90%. That’s because the company just admitted “improper conduct,” fired its CEO, and warned that it might default on its debt in April.
On top of that, Valeant is under investigation by the U.S. Congress, the Securities and Exchange Commission, and a few state attorney generals. And the company’s strategy of buying older drugs and raising their prices isn’t sitting well with regulators either.
In addition to Bill Ackman, hedge fund kings John Paulson of Paulson & Co. and mutual fund manager Robert Goldfarb, among others carefully studied the company, with all their years of experience and ability to crunch financial numbers, and still got it hugely wrong!
After a stellar 45-year career, Goldfarb is suddenly retiring because of the bad bet. And investors in his Sequoia Fund aren’t pleased with the losses either. I owned the Sequoia fund myself a few years ago, and then got out when I saw they were heavily over-invested in the energy sector, and I became uncomfortable with the large bet they were making in oil. The oil trades worked out, but, eventually, that strategy caught up with them, and they got burned on Valeant. Getting back to Bill Ackman, his fund, Pershing Square, is down 40% in the past year, wiping out three years of gains.
It’s possible that Valeant stock will turn around. Ackman himself has joined the company’s board, vowing to “identify new leadership.” But what’s happening with Valeant stock is a warning to all investors on Wall Street and Main Street of the pitfalls of getting too excited about one company.
So what went wrong here? Very simply, their over-concentration in just a few stocks, coupled with a high-degree of over-confidence in their own stock analysis. What sets Ackman’s fund apart is that he is a “high conviction” investor. That’s a fancy way of saying he only owns 10 stocks or less in his fund. When one of Ackman’s stocks soars or tanks, it has a huge impact on performance, so he’s playing an extreme form of stock-market Russian Roulette.
Compare that to a typical fund that owns 40 to 50 stocks and diversifies its monies across them. Through these examples, which I agree are a little extreme, I want you to understand the importance of diversification. And while it’s okay to put a small amount of money into funds like these, just make sure you do not bet the farm and go all in with these ultra-high-risk players.
The lesson is this: Actively managed funds’ main goal is to outperform some benchmark index. That index could be the S&P 500 or the Russell 2000, which tracks smaller companies or maybe other indexes which track overseas stocks. No matter what the index, these funds are getting paid extra to do better. Funds like Bill Ackman’s Pershing Square Fund are hedge funds, which generally charge a 2% ongoing fee plus 20% of the profit. This is a stiff price to pay, so you would only do it if you thought the payoff would be huge. Some hedge funds do make amazingly high returns, but most don’t, so in a sense it’s all a big speculation.
Getting back to the point, these funds make their extra return by taking big bets on just a few stocks. If these bets work out, they have justified their fees and everyone’s happy; if they don’t, you take your lumps.
The average investor shouldn’t get mixed up in any of these types of investment vehicles and should mostly invest in index funds. However, as I said before, if you want to take a smaller portion of your money and try to make a higher return, there is nothing wrong with that. Just remember, that getting a higher return generally will come with higher risk. So, before investing, think carefully and weigh the consequences to your future financial life if you get it wrong.