Equity investors endured some quick sledding in 2008, with the S&P 500 down over 39%. Though the hill was even more icy in 1931 (with the S&P down over 43%), this historic drop has left its mark on both the portfolios and investing habits of even the best investors.
Mohnish Pabrai, managing partner of Pabrai Investment Funds and author of The Dhandho Investor, is one such marked man. In his January letter to investors, Pabrai relayed that he was changing the size of his portfolio positions due to recent market foibles. In the past, Pabrai had sought to put 10% of a Fund’s assets into 10 investments. In practice, this was difficult to achieve, as market prices would move higher before the position was filled, some investments were too illiquid or thinly traded, or the market capitalizations of the target company were too small. Most often the Funds held 80% of their assets in 10 positions, with the remaining 20% invested in a handful of smaller positions. This strategy of concentration has served Pabrai well, and it coheres with the advice of his mentors Buffett and Munger, who counsel professionals to concentrate their investment portfolios.
However, Pabrai has now decided to size his normal positions at 5% of a Fund’s total assets. Strongly correlated positions will only warrant 2% of the portfolio, to prevent sector weakness from inordinately depressing annual results. In the rare case, perhaps every couple of years, Pabrai will size a position at 10%, but only “if seven moons line up.”
This is a significant change for a successful investor to make, and it contradicts the specific advice of two of his esteemed mentors, Buffett and Munger. And the primary reason for the change is “to temper volatility.”
At the risk of sounding disrespectful, I say turkey feathers (or choose your own animal excrement). As Pabrai himself acknowledges, this change will lower future returns for the Funds, though he assures that “we’ve given up a modest amount of the upside to gain a meaningful drop in volatility going forward.” Despite reassurances, the change runs directly contrary to his long-term investors’ interests. As Pabrai knows, volatility is a statistical device, and not a reliable proxy for risk. Volatility is the effect of Mr. Market’s manic-depressive behavior. Volatility is the intelligent investor’s best friend, for without volatility (particularly the depressive side of it), bargains would be less cheap.
The truth of the matter is that Pabrai has opted to allocate some funds from his best ten ideas to his second best ten ideas, in order to moderate the effect of any “mistakes” on his overall returns. This “solution” strikes me as far worse than volatility or mistakes. Even worse it suggests that Pabrai no longer fully appreciates the difference between his best idea and his twentieth best idea.