Eggs in a basket
In this post I will discuss why I think a portfolio of some ten to fifteen stocks is the right size for individual investors. I have previously written a post about concentrated portfolios. That post essentially made the point that a smaller number of stocks has been favoured by many well-known and highly successful investors.
In today’s post I want to come at the concentrated portfolio from first principles; what’s best from a risk and performance point of view.
Volatility is an undesirable thing
Generations of individual investors have grown up with the idea that proper diversification to manage risk meant having a portfolio of some 30 to 50 stocks. What they have been told is that a portfolio of 30 stocks will achieve some 90% of the diversification benefits that one would obtain holding the entire S&P 500 universe and a portfolio of 50 stocks almost the entire benefit.
The idea came from academic research. In 1952 a university study was made of diversification. Harry Markowitz carried out this work as a graduate student at the University of Chicago and ultimately earned a Nobel Prize. He showed that investment returns could be optimized for a given level of portfolio volatility through diversification. Volatility was thought to be the ‘undesirable thing’. Eventually, this undesirable thing morphed into risk, as volatility came to be viewed as a proxy for risk. This allowed ‘riskiness’ to be measured. This ‘insight’ provided the mathematical basis for an approach to investing which came to be called Modern Portfolio Theory (MPT). For a given level of volatility a calculable amount of diversification would provide an optimum return – an efficient portfolio. Correspondingly, for a given level of return the efficient portfolio would produce the least volatility.
This is patent nonsense. I have discussed this in a number of posts. For today’s purposes let’s simply see what Warren Buffett thinks of the idea.
Risk is the probability of loss
Warren Buffett wrote an article in the February 27, 2012 issue of Fortune. It was posted in CNN Money as CNN Money article . The article is titled: Why stocks beat gold and bonds. Buffett says:
“Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.” (Emphasis added)
It’s that simple. Risk is not measure by volatility. It is measured by the probability of loss over the contemplated holding period.
So what is investing all about?
We can answer that by looking at a comment made by Warren Buffett at the Berkshire Hathaway Annual Meeting in 1989: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”
What Warren Buffett says is no doubt true. There are four words to focus on: probability, possibility, gain and loss.
Before we look at gain and loss, let me offer an aside on ‘probability’ and ‘possibility’. We have to understand he is not talking about the mathematical calculations of probabilities. He’s talking about his intuitions of probabilities based on his experience as an investor. If investors were engaged in a game of roulette it would be possible to calculate the probabilities with real accuracy. The world of investing is too uncertain to make any such mathematical calculation, even for Warren Buffett.
What did Buffett mean by gain and loss?
Turning to ‘gain’ and ‘loss’, we need to think about what time frame he’s talking about. In order to make that clear let’s look at something from Ben Graham.
Graham wrote: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p101.
Let’s construct a portfolio with these thoughts in mind. We put $100 into each of ten stocks. At the beginning of year 1 our portfolio is worth $1000. In spite of all the ups and downs of the market we end year 5 with a nominal compounded total return over 5 years of 8% per annum. At the end of year five we will have a portfolio priced at $1,469. Will we be happy? I expect so.
Now let’s look at the same portfolio but with a real bump along the way. At the end of year 4 our portfolio is priced at $2,192. And in year 5 a bear market takes hold, and our portfolio is down by 33% that year. Our five-year return is identical at 8%. At the end of year five we are probably a bit unhappy.
Graham is talking about an ‘advance’ of 50% and a ‘decline’ of 30%. Are these ‘gains’ and ‘losses’ in the sense used by Buffett? I don’t think so. Buffett is talking about permanent losses. Graham is talking about volatility. And as we know, risk is not measured by volatility. Graham is simply making the point that volatility comes with the turf.
Buffett rationale for concentration
Buffett 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.” (Cunningham, The Essays of Warren Buffett: Lessons for Corporate America, 1998) p79 (emphasis added)
Basic rationale for concentration
When you buy stock in a company that qualifies to be added to your portfolio, you are investing in a superb company. It is a company that your investing experience, and analysis of the business, tells you has an outstanding business franchise. Your analysis further tells you that the franchise will allow it to generate a return on the capital invested in the company well in excess of its cost of capital five, ten or even twenty years in the future.
As well, to ensure you have a margin of safety to protect against making a mistake in your valuation, you will only buy it if it can be purchased at a very attractive price.
Both of these features of your investment process are calculated to reduce risk.
With this approach to investing, one puts fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. One’s knowledge and experience about the world and business are definitely limited. You need positions that will move the needle. As well, there are not that many superb companies out there. In addition, the companies in the portfolio and the economic sectors they operate in, need to be followed closely. This is easier with a smaller portfolio.
However, mistakes will be made. And this is where the next risk reduction feature fits in. With the kind of company you are investing in, if you have made a mistake, you will have lots of time to re-evaluate the company. That is, your mistaken assessment of the company will make itself known over many quarters of financial results. You will have lots of time to reverse your view of the company and sell the stock.
Our family’s retirement savings are in a portfolio of thirteen stocks. Things happen at a snail’s pace. In the last two years I have only sold two stocks. The first was a company with a great return on invested capital. But I realized over a period of time that it had very few chances to reinvest its excess capital at great returns. The second was a mining stock that became dramatically overpriced.
With a concentrated portfolio you get to know the company and its management very well. You get lots of warning signals if one of your companies starts to lose its way.
An argument against
I’ve heard one argument against concentration. It’s the idea that in a portfolio of say 30 stocks, most will have so so performance and a few will perform really well and pull the rest along. The idea is that if you concentrate your portfolio too much you will have less chance to ride the coattails of those winners.
One origin of this argument came from the outsized performance of the FAANGs in the period 2009 to 2020. In those days FAANG referred to Facebook, Apple, Amazon, Netflix and Google. There is no doubt that for several years, investors who had good positions in the FAANG stocks did very well. In fact, during those years, if you didn’t hold FAANG stocks your performance was likely trounced by the S&P 500 which, of course, had an outsized weighting in the FAANGs because of their growth.
This argument is not heard so much since tech stocks have come off the boil.
There is one big qualification. The following is from Warren Buffett’s Meeting with University of Maryland MBA Students – November 15, 2013, with notes taken by Professor David Kass:
Q (16) When managing other people’s money and making mistakes, how do you deal with the responsibility/burden?
WB: I tell them I’m going to make mistakes, but the goal is to do this and this and this. I might make mistakes in order to do this, but I will still probably achieve this goal. I try to operate in a way where I can’t lose significant sums over time. I might not make the most money this way, but I will minimize the risk of permanent loss. If there’s 1 in 1000 chance that an investment decision can threaten permanent loss to other people, I just won’t do it.” Individual investors can also think the same way when managing their own money. (Emphasis added)
Warren Buffett’s Meeting with University of Maryland MBA Students – November 15, 2013
The single dominant factor limiting a concentrated portfolio is the impact on a portfolio of a catastrophic idiosyncratic impact in any one position. A catastrophic idiosyncratic risk is one that utterly destroys the value of an individual stock or holding. This might be a bank destroyed by a rogue trader, an oil company destroyed by a massive oil spill or a drug company destroyed by a product suddenly killing a lot of people.
Idiosyncratic risks that are catastrophic and also highly unlikely are also called fat tail risks. That is, from a statistical point of view, they are at the extreme margins of the distribution curve. Idiosyncratic catastrophic risks are risks that are highly unlikely. They may be risks you can’t imagine. They haven’t ever happened before.
The way I deal with these risks is through a limit on position weighting. This means a maximum individual stock weighting, at least for the writer, of 15%. If my favourite stock goes on a tear and reaches 15% of the portfolio, I will sell it down to 10% no matter how much I like the company.
Let me end with a quote sourced here. On June 23, 1885 Andrew Carnegie addressed the students of Curry Commercial College of Pittsburgh, Pennsylvania.
He told the students: “The concerns which fail are those which have scattered their capital, which means that they have scattered their brains also. They have investments in this, or that, or the other, here, there and everywhere. “Don’t put all your eggs in one basket” is all wrong. I tell you “Put all your eggs in one basket, and then watch that basket.”” (Emphasis added)
To read more about diversification and balance check out the following posts:
Buying a stock – dating, not fully wedded
Fallacies around the truth of what drives the market
Most investors suffer from home bias
An overarching portfolio strategy
Let’s cut to the heart of how risk and uncertainty impact diversification
An all bank portfolio, ETFs and mistaken notions of diversification and balance
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