One investment rule "known by every school-boy", according to John Major when declining a request for compensation from a cashless City Council in the wake of the BCCI scandal was that "you should never put all your eggs in one basket".
The loads of eggs, loads of baskets theory is the dominant story recited by investment advisers when pushing the "balanced portfolio".
The aim of the portfolio would be to assemble a range of assets, regions and markets in a manner aimed at diversifying exposure to one area.
Warren Buffett, however, thinks that this egg theory is scrambled. For Buffett the risk actually increases when you spread too thinly, his command is "put all your eggs in one basket and watch that basket".
He does recognise though that watching eggs is a skill. Uninformed investors are likely to crack their eggs through mismanagement, and should therefore track indices and use fund managers. Different strokes for different folks depending upon how much information investors are prepared to work with before making a judgment.
Markowitz, on the other hand, would say that the baskets are a red herring, they shouldn't be needed. It's the omlette that matters.
Blending eggs with all sorts of other things in order to reduce risk and gain stable returns. Risk, in this context being defined more by standard deviation (volatility), rather than the exposure to a range of assets as per the balanced portfolio theory.
So how do you write the recipe for the egg thing when the sides of the argument are so extreme? Rule number one on the absolutely correct way to run a portfolio is that there are no rules.
Rule two is that you must make your own rules as, without rules, there are no benchmarks and standards against which the investor can manage their performance expectations. Big game, loads of money at stake, and no rules.
This weeks space is intended as a guide to developing your own rules.
There are three steps to the approach. Step One: The core of the recipe. Depending upon the investor attitude to risk this might occupy say 60 per cent to 80 per cent of the portfolio. This relies on lots of eggs and lots of baskets. Because of the number of baskets the Buffett Camp might call this the "shot gun" approach to investing.
Some of it has to be right. The "cheap" versions might use trackers for well-priced vehicles, although, according to The Cap Gemini/Merrill Lynch World Wealth Report, increasingly more high net worth individuals are using the "institutional approach" in which models are formulated by teams of quantitative and qualitative analysts. These guys needs lots of eggs from a variety of different sources.
Typically, the models are based on the analysts view of the global macro-economic scene. They are not influenced by "market chatter" or headline news unless that news is changing the overall macro-economic outlook.
Whilst they do not listen to Buffett on eggs, they would share his view on how long to cook them. For Buffett, "if you aren't willing to own a stock for 10 years don't even think about owning it for 10 minutes".
The aim of these analysts is to provide performance superior or near to equity indices without the volatility. Increasingly such models are incorporating a wider range of assets.
Step Two: the satellite assets. These add flavour to the recipe. Depending upon investor appetite to risk this part of the portfolio could occupy between 10 per cent and 25 per cent of the whole. The cooking time might not be long, and the choice of asset might be driven by "market chatter". Topical subjects for today could include: the BRIC countries (Brazil, Russia, India and China); oil, for those that haven't spotted the price increase; The UAE and local IPO opportunities; Eastern European property, to name but a few.
This is more like a rifle approach to targeting assets. The number of eggs and baskets will be drastically reduced.
The level of information required to make an informed decision is much greater and the level of courage to make the choice (and live with the results) will also be much greater. If the step one decisions are driven by macro-economics, these decisions are driven by micro-economics.
Decisions are based on one market, one target producing absolute returns in excess of the general run of performance expectations. Having taken the risk, you would expect the reward.
Step Three: now add the spice. Not everyone adds chilli to their eggs, and increasingly more regulators are inspecting the kitchens to ensure that the chilli is only applied to the appetites of experienced and professional investors.
The overall portfolio weighting should be restricted to, say, zero to 10 per cent of the overall portfolio depending again on appetite.
Ideally, the amount of eggs used should be limited. Buffett-style management might say that this is sniper-style investing. You should be selecting between one and ten assets depending upon the amount of money available.
However, every dirham invested has far fewer baskets from which to chose and the number of eggs on show would be few.
This part of the portfolio could include private equity decisions and specific stock selections. The aim is to get consistent high octane performance. This is the world of traders and stock pickers, like Stan Lock and John Goodlad quoted in Gulf News in the last few weeks that have been demonstrating performance well above their market benchmarks by making a limited range of decisions.
This is also the world of Warren Buffett, certainly not a trader, but one who shares the view that performance comes from a few but good selections. The Buffett style, is not a slow cook. A trader buys on the assumption that a rise in price will prompt a sell and a gain. Buffett leans more towards buying good assets at a fair price rather than fair assets at a good price.
The trader buys because of expected short term price movements, Buffett buys for medium/long term capital gain on an under-priced asset. This requires close analysis of every business in the Buffett portfolio.
If the other worlds are driven by macro and micro economics, Buffett would say "make your investments as a business analyst, not a security analyst", performance coming from the intrinsic value of a company, not the trend.
The writer is managing director of Mondial (Dubai) LLC.