Why Buffett is even smarter than I thought
It's funny how, the more I learn, the more I re-discover the same stuff that Buffett has been saying and doing for decades now.
Writing up "Searching for the Next Amazon, is it a bad idea?" I had another one of those experiences. I was describing the situation where an investment had done phenomenally well, and now represented a huge percentage of the portfolio. Even though this is a high class problem to have, it nonetheless causes a lot of stress for people in this situation. There isn't one obvious answer, and the trade-offs are unmerciful. Tax-reduction and risk-reduction point in opposite directions.
The best answer, then, is to avoid that type of situation altogether. An ounce of prevention... One way to do that is to diversify your investments from the outset. That way, when your portfolio starts to get concentrated (as some investments make a lot of money, while others go all the way to zero), you avoid having too much tied up in a single stock. This is a pretty good idea, I think.
But Buffett's solution is even better. First, because he favors defensive companies with a high likelihood of survival, he's unlikely to have many losers. It's not only Amazon's success (or whatever company "wins big") that creates that excessive portfolio concentration. There's also the fact that 9/10 similar investments will go to zero. Buffett typically doesn't make investments of that nature; he hates losing money under any circumstances.
Secondly, Buffett's investments tend to pay dividends. This means less and less of his money is tied up in that company over time, giving him capital to make other investments. He's taking money off the table, slowly and steadily.
Third, in extreme cases where a stock represents too much of his portfolio, he can issue shares of his own company to acquire other companies and diversify his holdings. This is what he did with the General Re acquisition to diversify out his then-expensive Coca-Cola investment. He changed his portfolio concentration not by selling the appreciated piece, but by adding to the whole!
Finally, and most importantly, Buffett has created a vehicle at Berkshire Hathaway that allows him to leverage his preferred investing style better than anyone else can. That General Re deal is a great example. In addition, the dividends that Berkshire receives on its investments create less of a tax drag at Berkshire than they would for many individual investors (this is because of the "Dividends Received Deduction" available to corporations). Another master-stroke!
PS: If you do have a lot of money tied up in a single stock, whether because of stock options, winning the investment lottery, or some combination of the two, that is still something I can help you with. As you probably realize, it is both really important and really difficult to know what the smart thing to do is. Just schedule an appointment and I'll be happy to help.
There's a great paper by AQR called "Buffett's Alpha," that dissects Buffett's investing style, according to academic factors. What they found was that Buffett does exactly what he says he does. He buys really high quality companies, he buys them cheaply, and he holds them forever. He also uses a good amount of leverage, which is something that's clear from his discussion of insurance "float," although he refrains from citing leverage as a key component of his success.
Morningstar recently put out a similar paper, without alluding to Buffett's record (even though he is the one who originally coined the term "wide-moat stocks"). What they found wasn't surprising. Wide-moat stocks have lower risk than other stocks. However, wide-moat stocks also have lower returns (though their risk-adjusted returns remain superior).
But then, when you factor in value, you get stocks that both outperform and have lower risk. And what do you know? That's exactly what Buffett's been saying for years.