Ten or Twenty for Pabrai’s Portfolio?

Yesterday I argued that Mohnish Pabrai’s recent decision to invest Fund assets in twenty 5% positions rather than ten 10% positions runs contrary to his investors’ interest. And the more I think about this altered strategy, the more convicted I become that it’s wrong. Permit me then to grapple with some of the main lines of defense for Pabrai’s position:

Defense #1 (the paternalistic defense): Investors get scared when positions move substantially lower, and then redeem their funds. It is in the investors’ interest to avoid or assuage such fear, so twenty portfolio positions will alleviate violent downdrafts and encourage more rational investor behavior.

Response: If we assume that Pabrai’s best idea is substantially better than his twentieth-best idea, then future returns will likely be lessened by this paternalistic action. Though it is in the investors’ long-term interest to remain committed despite short-term losses, their irrational behavior shouldn’t bother the manager much (so long as he isn’t levered and forced to liquidate the Fund at market bottoms). Thus, we have an apparent trade-off; either the investor endures market volatility and gets higher returns, or the investor takes less volatility and lower returns. The investors’ long-term interests are clearly best served in the former approach, and the fund manager seems better served in the latter. Keeping invested funds high keeps management fees high through bear markets.

Defense #2 (the “no big deal” defense): Even if this strategy shift trades performance for temperance, future returns won’t sag much. The twentieth-best idea is still a worthy idea.

Response: In the early stages of a secular bull market, one’s twentieth best idea will likely do fine. Cast aside the swim trunks and jump in! But over a three to five year period, it is fair to say that number 20 will lag number 1 by a couple of percentage points per year. In isolation, losing a few points of return is no thing, but compounded over a decade, such a drag will significantly affect one’s overall performance. Also, any additional time spent working on ideas 11-20 will likely detract one’s attention from future opportunities.

Defense #3 (the “diversification lowers risk” defense): Giving up some performance is acceptable because greater diversification entails less risk.

Response: This strikes me as plainly false. The best investment idea is the one with the best prospects and the greatest margin of safety. To diversify capital from one’s best idea to one’s merely ‘good’ ideas means accepting a smaller margin of safety, and in no way can that strategy be less risky. The only way diversification is less risky is if one fears that his inner psyche will compel him to sell his best idea if it declines the overall portfolio too much. In that case, diversification serves more as a psychic crutch rather than a risk-management tool.

Defense #4: (the “loss mitigation” defense) Diversifying fund assets into twenty positions means any mistakes will impact the portfolio returns less.

Response: Though the point is accurate, the other side of the coin is that future successes will also impact portfolio returns less. For managers like Pabrai, future successes will far outnumber mistakes, especially given Pabrai’s method of betting when he can’t lose much. Even when faced with a handful of mistakes, one has to discern whether they signify that his approach is broken, or his fortune briefly turned. If only the latter, mistakes should not consume one’s virtue.

4 responses to “Ten or Twenty for Pabrai’s Portfolio?

  1. wonderfully stated, sir!

  2. I like the new look. I might have to change my name and run a hedge fund.

  3. Hammer Advisors? They’ll think you belong in Sears. The Hammer Fund? The Golden Hammer Fund? :)

  4. Defense #5

    Since equity markets are down so much, Pabrai now sees tons of opportunities which are just as great as another.

    If you see 20 great ideas to invest in, which certainly is possibility when markets are down 40-50%, why give 10 of them up and spend time agonizing over which one’s slightly better?

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