Concentration or Diversification

egg-basketOver the last couple of days, we’ve argued that it is a mistake for Mohnish Pabrai, or other successful investors, to expand the number of positions in their portfolio in order to lessen volatility. Yet, you’ve heard enough from me; what do the professionals have to say?

In You Can Be a Stock Market Genius (Simon & Schuster, 1997), Joel Greenblatt, whose annualized returns at Gotham Capital from 1985-1995 were 50%, states that a concentrated portfolio of five securities will only carry 3% more downside potential (within one standard deviation of the mean) than a portfolio of fifty securities. Said differently, a portfolio of fifty securities stands a two out of three chance of returning between -8% and 28%; a portfolio of five securities stands a two out of three chance of returning between -11% and 31%. The returns on ten securities should fall between -10% and 30%. In short, there isn’t a significant difference in variability if one owns five, ten, twenty, or five hundred securities.

Warren Buffett’s compounded annual partnership returns from 1957-1969 were 31.6%. Though it is not easy to determine the relative size of the partnership’s positions, it is well known that Buffett put 40% of the partnership’s assets into American Express during the Salad Oil Scandal of 1964. Martin and Puthenpurackal found that “Berkshire Hathaway’s portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value.” As Buffett himself has said, “if you really know businesses, you probably shouldn’t own more than six of them. If you can identify six wonderful businesses that is all the diversification you need… going into a seventh one, rather than putting money into your first one, has got to be a terrible mistake.” Buffett has even gone so far as to say that he would have been willing to allocate up to 75% of his portfolio in the distressed assets of Long Term Capital Management in 1998.

Charlie Munger, Buffett’s partner at Berkshire, has quipped that you could be adequately diversified if you owned the best office building in town, the best apartments in town, the dominant car dealership, and the highest grossing McDonald’s.

Now, to be clear, these three are speaking primarily to dedicated investors willing to devote time and intensity to studying businesses. Broad diversification achieved through index funds is likely the best strategy for the majority of market participants. But for those who make it their profession to beat the market’s returns, concentration is an important component of success.

All told, this series gives voice to my growing conviction that the majority of one’s investing returns will come from a few great ideas. Looking at Buffett’s returns, substantial gains came from relatively few holdings—National Indemnity, American Express (the first time), Geico, See’s Candies, Capital Cities, the Washington Post, and Coca Cola. Though countless reasons can be offered for diversifying, it is hard to argue against the success that has followed his concentration.

4 responses to “Concentration or Diversification

  1. I’m just a newbie with a questionable record so far but I’m definitely in the concentrated portfolio camp (I have to admit that my portfolio isn’t that large though.)

    A concentrated portfolio will cause massive losses if you are wrong. I certainly can give my example of Ambac, which was a total disaster. Since most of us are just amateurs who don’t know if we are cut out for investing, I think if one cannot tolerate large losses, they should rule out concentrated portfolios. It doesn’t matter what you invest in or how confident you are. You can make a mistake. The investment can also blow up for reasons outside your control (e.g. fraud, take-under at very low prices when the stock drops, etc.) So I think if one cannot suffer losses, it makes sense to avoid concentrated portfolios.

    Having said that, I’m in the concentrated portfolio camp and share similar views as yourself. I really believe that diversification gives an illusion of safety more than any real safety.

    First of all, I don’t think it’s possible for an average investor, certainly not amateurs who don’t spend 9-5 analyzing stocks, to know the companies they invest in. Due to various circumstances in my life, I am more dedicated to investing than many I encounter online and even I have problems knowing more than a few companies. I would argue that diversifed investors are mistaken in their view that they know the companies they are investing in. They don’t. They probably could learn a lot more about the company or the industry if they narrowed it down.

    Secondly, how many diversfiied investors actually came out alive after the current stock market crash? Unless you were overloaded on government bonds or US$, you got killed as much as a typical concentrated investor last year. This is one of the reasons I don’t see the benefit of Pabri’s switch right now. If he is suggesting that diversification would have saved him last year, he should check out the diversified investors or even a comparable mutual fund.

    Also, my opinion is that one doesn’t need a large number of holdings to be diversified. Instead, it is far more important to have lowly correlated assets. A few holdings in industries that don’t move together will be far better than trying increase the number of holdings.

  2. You’re definitely right; mistakes will hurt. One may think that having more positions will mean that the mistakes will hurt less, but I doubt it. In fact, the mistakes may actually increase because one’s attentions are stretched thin. And even if the mistakes hurt less, one’s performance will suffer, and that should hurt too.

    Regarding the average investor, I suspect that it can be done with less time, but one really needs to know what kind of research it takes. For example, if he goes on Value Investors Club, and finds a good, concise write-up that hits on the important stuff–ROE, ROA, debt levels, competitive advantages, capital allocation, then he should have a good feel for what work needs to be done. I expect that a part-timer could do that for ten companies a year. Of course, you have to focus on the relevant metrics, and you can’t get consumed with all the extra stuff.

  3. I may be wrong here, but as the economy dumped, I believe Greenblatt started to buy EVERYTHING. Not just additions to his existing holdings but a majority of the companies that showed up in his magic formula screen.

  4. I know that Gotham Asset Management had three holdings as of 12/31/08–Ambassadors Group, Ark Restaurants, and Telemig Celular.

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