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Diversifying across different asset classes can be a strategy to try to manage risk in a portfolio. But this is not what billionaire investor Warren Buffett thinks investors should do.
According to the big man's investment vehicle, Berkshire Hathaway It currently holds around 25% of its total assets in cash and cash equivalents. However, Buffett's advice to shareholders is quite different.
Buffett's advice
At an annual meeting, Buffett offered Berkshire shareholders the following advice on how to manage risk:
We believe the best way to minimize risk is to 'think'…have your default position as always short term instruments and whenever you see something smart to do, you should do it.
The idea is simple. Instead of trying to balance stocks with bonds, investors should keep their money in something they can easily access until they see a long-term opportunity.
However, opportunities to buy shares of prominent companies at attractive prices do not present themselves often. That's why it's important to be prepared to make the most of them when they arise.
Thought
According to Buffett, the key to minimizing risk is to think. That means identifying companies that have excellent future prospects and determining what a fair price for them might be.
Believe InterContinental Hotel Group(LSE:IHG) is a great example. The company has 6,430 hotels in its network and another 2,225 in the pipeline.
Franchising its stores means IHG has relatively low running costs. As a result, 90% of the cash the company generates can be invested for growth or used for dividends and share buybacks.
The company is also protected by high switching costs for operators. Once hotels are part of your network, switching to another franchise is complicated and expensive.
Valuation
There are many things about IHG that are attractive from an investment perspective. But there are also risks to consider when determining how much you should be willing to pay for the stock.
One of them is the emergence of Airbnbthat continues to expand. This is a strong competitor that could make it difficult for IHG to continue increasing its market share in the future.
Right now, IHG stock is trading at around 25 times free cash flow. That's high, but given the company's attractive economic and growth prospects, I don't think it's entirely unreasonable.
To try to minimize risk in my own portfolio, I would look for a better margin of safety before purchasing. That could be due to an improving outlook or a lower price.
Manage risk
According to Buffett, the way to minimize risk is not to maintain a fixed allocation to different asset classes. It means thinking carefully about companies and their value.
Good investing involves buying stocks when they are trading at attractive prices. And solving this involves understanding what the company's long-term prospects are.
This is not always possible for all companies. But that's okay: As Buffett says, investors only need to find a few great opportunities to get extremely good results over time.
