Diversifying into different asset classes can be a strategy for trying to manage risk in a portfolio. But this isn’t what billionaire investor Warren Buffett thinks investors should do.
According to the great man’s investment vehicle, Berkshire Hathaway currently holds around 25% of its total assets in cash and cash equivalents. Buffett’s advice to shareholders however’s quite different.
Buffett’s advice
At one annual meeting, Buffett offered Berkshire’s shareholders the following advice about how to manage risk:
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We think the best way to minimise risk is to ‘think’… have your default position as always short-term instruments and whenever you see anything intelligent to do, you should do it.
The idea’s straightforward. Instead of trying to balance stocks with bonds, investors should keep their money in something they can access easily until they see a long-term opportunity.
Chances to buy shares in outstanding businesses at attractive prices don’t come around often though. That’s why it’s important to be ready to make the most of them when they do arise.
Thinking
According to Buffett, the key to minimising risk is thinking. That means identifying businesses that have outstanding future prospects and figuring out what a fair price for them might be.
I think InterContinental Hotels Group‘s (LSE:IHG) a great example. The company has 6,430 hotels in its network, with another 2,225 in the pipeline.
Franchising its venues means IHG has relatively low maintenance costs. As a result, 90% of the cash the firm generates can be invested for growth or used for dividends and share buybacks.
The company’s also protected by high switching costs for operators. Once hotels are part of its network, changing to a different franchise is both complicated and expensive.
Valuation
There’s a lot about IHG that’s attractive from an investment perspective. But there are also risks to consider in working out how much they should be willing to pay for the stock.
One of these is the rise of Airbnb, which continues to expand. That’s a strong competitor that could make it more difficult for IHG to keep growing its market share in the future.
Right now, IHG shares are trading at around 25 times free cash flow. That’s high, but given the firm’s attractive economics and growth prospects, I don’t think it’s entirely unreasonable.
In order to try and minimise the risk in my own portfolio, I’d look for a better margin of safety before buying. That could come from an improved outlook, or it could come from a lower price.
Managing risk
According to Buffett, the way to minimise risk isn’t by maintaining a fixed allocation to different asset classes. It’s by thinking carefully about businesses and what they’re worth.
Good investing involves buying stocks when they trade at attractive prices. And figuring this out involves understanding what the company’s long-term prospects are.
This isn’t always possible for every business. But that’s ok – as Buffett says, investors only need to find a few great opportunities to do extremely well over time.
