For the know-something investor
I invest all our retirement savings in a fairly concentrated self-managed portfolio of equities. Today it would be called high conviction investing. There are 13 stocks in the portfolio. Since the fall of 2002 we have had a 100% equity allocation. No bonds.
In this post I propose to look at what some of the most successful investors in history have said about portfolio size and add a few practical observations.
We have to start with Warren Buffett
He tells us: “…if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.” (Buffett, 1998, The Essays of Warren Buffett: Lessons for Corporate America.)p.79
A current take
Joel Greenblatt explains: “One of the reasons I can have a concentrated portfolio is because I understand what I own…. If you own six or eight great things, or at least great bets, that’s more comforting if you actually know what you own. If you don’t know what you own, if you don’t know how to value a business, you’re just going to react to the emotions, because you don’t actually understand what you own. But if you actually understand what you own, and the premise that you bought those things with is still intact, that’s actually the only way I think you can deal with the emotion, because you realize what you own is still good.”
For readers who don’t know of him, Joel Greenblatt serves as Managing Principal and Co-Chief Investment Officer of Gotham Asset Management. For over two decades, Mr. Greenblatt has been a professor on the adjunct faculty at Columbia Business School teaching “Value and Special Situation Investing.” He is also a very successful author of investment books.
We can go back a bit
Bernard Baruch, one of the most successful investors of the early 20th century, gave this advice for individuals: “Don’t buy too many different securities. Better have only a few investments which can be watched.” (Pring, Investment Psychology Explained, 1990) p.245. (Baruch, 1957)
In a similar vein, John Maynard Keynes (also a brilliant investor), expressed the view, in a letter written to a business associate, F.C. Scott, on August 15, 1934:
“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits risk by spreading too much between enterprises about which one knows little and has no reason for special confidence….. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.”(Buffett, 1998, p.81) (Emphasis added)
This letter was written not long after the stock market crash that heralded the Great Depression. In earlier years, Keynes had been a great trader, buying and selling commodities and other highly speculative instruments. In time, he became a real investor. In 1934 he was managing the Kings College Cambridge investment fund as well as his own portfolio, with great success.
Philip Fisher, whose writings were a significant influence on Warren Buffett, was an advocate of limited diversification. His philosophy simply was that there are a very limited number of truly excellent companies and that when you find them you should invest substantial portions of your portfolio in them. Fisher considered it a mistake to over diversify.
Fisher wrote: “…among investors with common stock holding having a market value of a quarter to a half million dollars [in 1958 dollars], the percentage who own twenty-five or more different stocks is appalling. It is not this number of twenty-five or more which itself is appalling. Rather it is that in the great majority of instances only a small percentage of such holdings is in attractive stocks about which the investor or his advisor has a high degree of knowledge.
Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all.” (Fisher, 1958,1996)p.135. (Emphasis added)
The research supports this
A paper titled “Conviction in Equity Investing” by Mike Sebastian was published in 2014 in The Journal of Portfolio Management. It reports:
“Strategies that are highest-conviction on the part of the manager — higher active risk, less benchmark-sensitive portfolios — offer demonstrably better odds of success. Most institutional investors take a disproportionately small amount of risk with active management compared with the resources spent on the effort and reasonable expectations for value added.” (Emphasis added)
For reference to paper see here. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2176862
The problem with high diversification
In one of his letters to his investors in the 1960s, Warren Buffett sheds light on the problem. He commented on the failure of the average mutual fund to outperform the indexes. As reported by Roger Lowenstein: “Why was it, [Buffett] wondered, that “the high priests of Wall Street,” with their brains, training, and high pay, couldn’t top a portfolio managed by no brains at all? He found the culprit in the tendency of managers to confuse a conservative (i.e., reasonably priced) portfolio with one that was merely conventional.”
Lowenstein elaborates, “It was a subtle distinction, and bears reflection. The common approach on owning a bag full of popular stocks – AT&T, General Electric, IBM, and so forth – regardless of price, qualified as the latter, but surely not as the former. Buffett blamed the committee process and group-think that was prevalent on Wall Street.” (Lowenstein, 1995,2008, Buffett, The Making of an American Capitalist) p.85. (Emphasis added)
The explanation for the conventionality of institutional money managers is explained by John Maynard Keynes. As he put it succinctly in The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes, 1936,2007, The General Theory of Employment, Interest and Money) p.158.
My own rules
The writer’s rule is that a full investment position in a superb company will have a weighting of between 5% and 10% in the portfolio. This would be an investment in which the writer has the highest level of confidence, the highest level of belief, and which is purchased with a substantial margin of safety.
The stocks of companies with high potential, co-invested management, but which are somewhat more risky and in which the writer has a lower level of confidence, are limited, initially at least, to between 2.5% and 5% weighting. They will naturally only be purchased with a substantial margin of safety.
Over the last fifty years the writer’s portfolio has been as high as thirty stocks. In the last ten years the comfortable number seems to be between 12 and 15 stocks.
If the price of a stock goes up so that it makes up 15% of the portfolio, I will sell it down to 10%. This is because I am concerned about idiosyncratic catastrophic risk that could destroy any company in a heartbeat. In such a horrendous event I would never, ever want to suffer a loss of more than 15% of the portfolio.
I have seen many portfolios with no diversification. A single stock no matter how good (e.g. Apple) is foolish. I have seen people with four bank stocks thinking that banks are solid and that four provides diversification. That is also foolish. And so on.
As in all of investing there is an investment psychology side to this issue. The strength of our convictions is no measure of their validity. To read about this see my post: The frailty of high conviction ideas
The number of stocks one holds is only part of the story around diversification. As well, there is a related topic, balance. It is just as important.
To dig further into the subjects of diversification and balance, check out these posts:
An all bank portfolio, ETFs and mistaken notions of diversification and balance
Lessons from the world of gambling
You can reach me by email at email@example.com
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