The importance of strategic thinking in portfolio management

Warren Buffett's chairmans letters Berkshire Hathaway shareholders are always worth a read. In 2018, he took an especially poetic approach when he described his group’s investment portfolio as being like a “forest”.

Investors can learn from this analogy when they ponder their own portfolio construction and management.

Berkshire’s many and diverse businesses, he said, were its “economic trees”. Like any portfolio, it has an array of specimens (in Berkshire’s case there are vast numbers of them). They range in size from twigs to redwoods. And while a few trees are diseased and likely to die in the decade ahead, he said, “many others are destined to grow in size and beauty”.

This was Buffett hitting his poetic stride. He took the arboreal theme a step further by splitting the forest into five important “groves” - an analogy to help onlookers overcome their “mind-numbing” analysis of individual businesses, or trees. His point was that you don’t need to assess every single tree to make “a rough estimate of Berkshire’s intrinsic business value”.

Now to be fair, the read-across for regular investors isn’t all that straightforward. With Buffett’s resources, I’d hazard you could be fairly relaxed about the odd disaster or bad decision. Most of the rest of us quite rightly take those things pretty hard.

But the point still stands that, even though his portfolio is on a far greater scale than most, Buffett’s diversified approach lets him think strategically rather tactically. Taking a 50,000ft view means he can be sanguine when things don’t go right and focus instead on whether the overall campaign is paying off. This is where the lesson is.

Are we building our portfolio with a firm strategy in mind?

Let’s say you had a lump sum to invest in the market to bolster your portfolio. Perhaps you’re ready and waiting to deploy the new year ISA allowance. How would you do it?

Well, if you’re a typical investor, the answer is apparently that you’ll do it in a fairly naive way. That’s the finding^[1] of a team including John Gathergood at the Nottingham School of Economics and David Hirshleifer, the American economist and behavioural scientist.

They discovered that when buying multiple stocks on the same day, many investors simply divide their funds equally across the different shares and don’t think any more about it. Gathergood and Hirshleifer called this Naïve Buying Diversification.

And the study went a step further, pointing to another problematic trait known as Narrow Framing.

Narrow framing is all about making decisions without thinking about their wider impact. Like the impact a stock purchase might have in the context of a portfolio. In psychology, you can find examples of framing in all aspects of life. But in investing specifically, it can lead to all sorts of potentially costly mistakes.

For instance, randomly buying a stock because it has caught your eye or it’s been tipped somewhere, might feel harmless enough. But if your portfolio is already over-laden with similar stocks, you could become over-exposed. It might mean that you’re too heavily weighted to speculative mining stocks, or pre-profit growth plays, or small-caps or even contrarians… whatever it is, the essence of the problem is that the narrow framed decision can have hidden consequences for the portfolio.

Building a well-rounded portfolio

When building and managing your portfolio, it is important to think about the role that each stock plays - try and take a more portfolio-based approach and think about the overall strategy. That means worrying less about individual stocks and seeing the bigger, long-term picture rather than focusing on the minutiae to the detriment of everything else.