Portfolio management
Of eggs and baskets
I’ve seen serious diversification problems with the portfolios of individual investors I’ve looked at. They fall into three categories: overdiversification, under diversification and lack of balance. In this post I’ll offer my thoughts on the right number of stocks to own.
We can start the discussion with a few quotes.
Peter Lynch wrote: “A foolish diversity is the hobgoblin of small investors.” He offers the thought that in a small portfolio he’d be comfortable owning between three and ten stocks. (Lynch, One Up on Wall Street. 1989,1990) p242
Peter Lynch wrote One Up on Wall Street in 1989. At that point he had been in the investment business for twenty years and had been manager of the Fidelity Magellan Fund since 1977. In 1989, the Magellan Fund had one million shareholders and the book jacket says that if you had invested $10,000 in the Magellan Fund when Lynch became manager, ten years late you would have had $190,000. It was a heady time and the tone of the book reflects this.
Warren 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)
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.” (Emphasis added)
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.
One final quote
“Concentrate all your thought and energy upon the performance of your duties. Put all your eggs into one basket and then watch that basket, do not scatter your shot…. The great successes of life are made by concentration.” (Emphasis added)
—Andrew Carnegie, The Pittsburgh Bulletin, December 19, 1903,
Conventional diversification
The investment world seized upon the work of Harry Markowitz in 1952 as something of a revelation. Markowitz is thought to have shown that investment returns could be optimized for a given level of risk through diversification. With charts and formulas and lots of math he studied risk, return, correlation and diversification. Originally his work was focused on volatility rather than risk. He felt that volatility was something investors disliked and he made his calculations to optimize returns for a given level of volatility. He later adopted the idea that that while risk could not be measured directly, he could assume that volatility acted as a proxy for risk. Markowitz received a Nobel Prize. Since that time, by and large, the investment industry has accepted that volatility is a reasonable proxy for risk and hence accepts Modern Portfolio Theory and all that follows from it.
This approach has led to what today may be thought of as conventional diversification.
In a recent post I explain why this volatility as risk approach is fundamentally flawed.
Using conventional diversification, math wonks have concluded that a portfolio with about 35 stocks will produce a risk profile very close to the S&P 500. A lot of advisors, pundits and commentators have seized on this to suggest that individual investors should have portfolios of some 35 stocks. It is utter nonsense.
My experience
Over the last fifty years of stock investing my portfolio has ranged from a high of about 25 stocks in earlier days to a range of 10 to 15 currently. Today there are 14 stocks in my portfolio. Because I don’t worry about volatility (I actually try to take advantage of it), our family’s retirement savings have comfortably survived bear markets, panics and bursting bubbles quite well.
The driving factors behind the number of stocks in our family’s portfolio are as follows:
The first factor
The first factor is that I do not allow any stock in the portfolio to have a portfolio weight of more than 15%. This is because any stock/company is subject to catastrophic idiosyncratic risk. This is the risk that a rock solid bank might be totally blown away by the fraud of a rogue trader, that an oil company might be completely destroyed by a massive oil spill, and so on. In an absolute worst-case scenario, I am not prepared to lose more than 15% of our financial worth in one horrific incident. If a stock in our portfolio performs magnificently and reaches 15%, I will sell it down to 10% regardless of valuation and how much I like the company.
The second factor
The second factor favouring 10 to 15 stocks is that I will only invest in superb companies. There just aren’t that many of them. There are lots of rock-solid companies that are institutional investor favorites that I wouldn’t think of investing in. They may be rock solid but they have little opportunity to invest their free cash flow profitably for the future. As Warren Buffett put it, as quoted above, “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 third factor
The third factor is the need to monitor one’s investments. This is Andrew Carnegie’s advice to “watch that basket.” I probably spend a half day each week reading quarterly reports, transcripts of calls with analysts, an online news clipping service from my discount broker, as well a print media stories about the industry or sector our stocks/companies are in. With a more concentrated portfolio one gets to know the companies in the portfolio well. After all, one’s favorite holding period should be forever. Naturally some weeding is required from time to time.
The final factor
The final factor is balance coupled with diversification. This is a factor that causes me to hold more than the 3 to 10 or 5 to 10 stocks than are mentioned by Buffett, Lynch and Greenblatt.
To understand balance and diversification one has to understand business correlation. This needs some explanation as there is a whole lot of confusion around the subject of correlation.
When most investors think of correlation they think of price correlation. That is, they think of it as the tendency of the prices of certain stocks or sectors to move together with each other or with the market as a whole. And, many portfolio management services offer price correlation charts. They will show in an instant the price correlation between stocks in the investor’s portfolio. For investors, what is more important is business correlation.
Price correlation can give a false picture. It can suggest business correlation where none exists. It can fail to show business correlation where it does exist.
To have proper diversification and balance in a portfolio one needs to understand the business correlation of the different stocks/companies.
Diversity and Balance working together
Let me offer an example. To give our portfolio some diversity and balance it would help to find stocks in sectors that react differently to interest rates. Often what is bad for lenders is good for borrowers. The real estate sector which includes REITs, public commercial real estate companies, home builders, building supply stocks and so on, are good candidates. They like low interest rates. When interest rates are falling REITs are able to renew mortgages at ever lower rates and their funds from operations improve even if they haven’t raised rents or increased profitability in other ways. In that same falling interest rate environment banks’ interest rate spreads get squeezed more and more. This would be an example of an inverse business correlation, or hedging, between sectors. But it doesn’t exist all the time. Real estate developers and builders tend to over build. When a recession comes along a number of players in the real estate sector go bust and the banks are left holding the bag. In that case both the borrowers and the lenders suffer.
To diversify our simplified portfolio, we might think of broadening out into life insurance companies. That really doesn’t help as life insurance companies are also sensitive to interest rates and in the same direction as banks. When rates rise both banks and life insurance companies do better. When rates fall, both banks and life insurance companies do worse. You get the idea. There is business correlation and inverse business correlation across various sectors. You can build a portfolio where weakness in one sector is covered off by strength in another or where industry or sector cycles are not coincident. You can look at international diversification in the same way.
Conclusion
Over the years, through trial and error, I have come to the conclusion that to cover enough industries and sectors to give our portfolio diversification and balance (from a business correlation point of view) I need more than the number of stocks suggested by Lynch, Buffett and Greenblatt. 10 to 15 stocks seem to give me about the right number to work with. The idea is that they operate like a sports team.
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To dig a bit deeper into diversification and balance take a look at the Motherlode Chapter 36. Diversification, balance and strategy
That chapter is divided into Sections with titles as follows:
36.02 Digression to idiosyncratic risks and unexpectables
36.06 An aside on industrial commodities and agriculture
36.07 Correlation and the business cycle
36.08 A sector rotation strategy
36.12 Thinking about currencies in the context of diversification
36.13 International diversification
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
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