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Why Concentration Can Be A Terrible Idea


theasiareport
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Read an article from Kiplinger which was surprisingly frank from a hedge fund manager who is winding down his operations after 15 years. Managing OPMI is a completely different ball game.

 

http://www.kiplinger.com/article/investing/T052-C018-S002-why-this-hedge-fund-manager-is-shutting-down.html

 

Here's the bit which I liked:

 

First, that I took a big risk when I created a portfolio that was wildly different from Standard & Poor’s 500-stock index. That was especially problematic in 2014, when hardly anyone beat the index.

 

Magnifying the problem was my decision to put too much money into my favorite ideas. I totally bought into the notion that it was foolish to invest in my 60th-best idea.

 

What I overlooked was how bad things could get if I was wrong about my second-best, third-best and fifth-best ideas at the same time.

 

 

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I think other people have discussed this before, but when you're going to go for concentration, you need to make sure that your hit rate is pretty high. Maybe the 85%+ range. Otherwise, you get unfortunate results.

 

The underlying assumption of saying that you shouldn't put more money into your twentieth best idea if you can put more money into your best idea is that you are very seldom wrong on your ranking of ideas.

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Guest notorious546

I think for people later on in their career a concentrated is probably a better approach, as that could have given them time to learn from a few more mistakes and build up some industry knowledge.

 

I've been concentrated since the last year two years and it has resulted in some short-term negative results.

 

 

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"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

 

Safety in principal is the key to me for concentrated positions. If he's investing in Facebook at 16x revenue, a pre-revenue pharma company and highly (understatement) levered bank stocks he's taking speculative positions. I'm not sure anyone ever advocated a concentrated portfolio of speculative positions. That's asking for disaster. I don't know anything about ZINC or SUNE, although I know they're local favorites.

 

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Guest notorious546

How long do people consider "enough experience"?

 

My own understanding of Buffett is that he spent years accumulating experience in the "Graham" camp before slowly transitioning out of it.

 

depends. not sure if there is a clear answer. However long it takes you to learn the "essentials". pretty subjective.

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My impression from reading The Snowball and a few other books is that Buffett started out really concentrated with his own money and diversified more when he was running other people's money.  I think that is what I'd do too.  If you've been lucky enough to get a fund going and you can beat the market by a few points, you've got something pretty good going for you, so the thing to do is just don't screw it up.

 

If the market goes against you in your personal portfolio, all you have to worry about is whether your assessment of the business has changed.  When you're running a fund you are also worrying about whether your investors change their mind about you before the market changes its mind about your stocks.  Of course that is true whether you hold 1 stock or 100, but concentration comes with higher volatility and more risk of your investors bailing on you.

 

I think Walter Schloss and Graham are good models to follow for managing a fund.  Focusing on downside protection and staying diversified keeps your investors from freaking out and keeps you alive to fight another day.

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How long do people consider "enough experience"?

 

There are a lot of people for whom "enough experience" leads to being less certain about investing choices rather than more.

The more you know, the more you know that you really don't know anything.

 

In the opposite edge case you have young smart guys with no experience, small portfolios and long career/job runways putting everything into 2-4 ideas and succeeding for a while (sometimes quite spectacularly). And they wonder why would anyone hold a diversified portfolio...

 

Of course there is always also Munger (66% of DJCO portfolio in WFC - that's balls of steel, though perhaps DJCO shareholders don't care?). BTW, Buffett is not concentrated for a long time now, especially considering the op businesses. Though even with that, IBM is just balls of steel IMO. Even more than Munger's WFC in some ways.

 

Ultimately concentration vs. diversification one of the perennial topics that pops up periodically and never gets resolved, since there is no resolution.

Same as small caps vs. large caps.

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How long do people consider "enough experience"?

 

My own understanding of Buffett is that he spent years accumulating experience in the "Graham" camp before slowly transitioning out of it.

 

Buffett started out concentrated, even as a boy when he had hardly any experience.  As a teenager he happily put all his savings from paper route into a couple of names.  He continued through most of his career to be a concentrated investor.  As a more experienced investor after a few years with Graham he put most of his net worth into Geico.  He also put a large percentage of Buffett Partnership money into Sandborn Maps and then Berkshire Hathaway.  And then later into Amex and then later again into Coca Cola.  For the last 20 years however I'd say he has been diversifying.  I would say that he was concentrated at all stages of inexperience and experience and with his own and other peoples money until he had achieved massive wealth and size.

 

My interpretation of this is that he adored investing and he did what came naturally to him at a young age when he could have afforded to lose his investment.  Subsequently I think he was happy to concentrate because he knew a lot about investing and he was very confident in his abilities.

 

Im skeptical of drawing lessons from Buffett to then apply to yourself.  But some things I'd want to think about are:

 

Are you are a very good investor?  If so then probably concentration is the best way to go.  If you are not then it is best to diversify. 

 

How relevant are these other factors to your situation? , age, job, responsibilities etc.  If you are 70 with significant savings you are in a different situation to a 24 year old with small savings, even if you have the same investing experience and skill.

 

There is a difference between extreme concentration, say 5 or fewer ideas. And concentration like Lou Simpson of around 10 ideas.  The ten idea portfolio can take the occasional flop, if most of the time you're good. 

 

Also I think there is a difference between owning say an extreme concentration of: Berkshire, Exxon, Johnson&Johnson and Nestle.  And a 10 stock portfolio, equal weighted, made up of say, the top ten ideas off the Investment Ideas page of this site. (I think the 4 company diversification is safer and in many important ways, more diversified).

 

If you are in doubt then lean towards a diversified portfolio and/or large diversified businesses.

 

 

 

 

 

 

 

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Ya, I have to chime in on concentration.

 

On the face of it, you can't argue with the saying that if you are sure of your

best idea why not add to it as opposed to adding to your fith best idea. There

is only one argument.  You don't know if you are wrong...... It is similar to

Howard's Marks second level thinking. Rumsfeld calls it the known unknowns, if

you are good. You know what you don't know.  If you are not good, well then you

don't know what you don't know. That's the biggest danger in my opinion.

 

I think it was Pabrai who tried to apply 2nd order thinking with the kelly

theorem. To me that is ludicrus.  He may have some bias with leads to flawed

analysis and now he compounds the problem by using the bias to evaluate

himself.  The kelly theorem or any other math tool is only as good as the data

in.  No wonder he doesn't use it now.

 

So with the article author appears he didn't calculate his odds correctly, and

sized his positions wrong. So he didn't know what he didn't know.  The

mitigating factor may be that he is always under pressure to outperform so he

took bigger risks than necessary.

 

I think it is the wrong with many managers who blow up their fund. I am not

saying the author blew up his fund, he just had a few years of

underperformance.

 

Now he says he will migrate to index funds for his personal money. which means....... he now knows

what he doesn't know.  That's what I admire about the people in the Bogleheads

forum. They admit their limitations and hence they probably outperformed the

author of the article!

 

I am very uneasy about the 2nd order stuff, so I always have 20 positions. In

addition, they are diversified in different countries in different industries.

A portfolio of 20 commodity positions is not diversified.  I started hard core

investing late, so I have a decent nest egg but I cannot replace it. So I can

play with smallcaps, obscure markets so long as I size and diversify

conservatively. There is lots of time in a lifetime, if I convince myself I am

good then maybe I will later have 5 positions, like the manager at Curreen

Capital.

 

Stocks are like the tide, only it goes up and down in years or decades so a lot

of people with sexy strategies will do well in a bull market but then the tide

goes out then we see the sexy people naked.  I see a lot of people in

blogsphere and hedge fund world who have outperformed starting in 2013 or so. I

have a suspicion some of them will blow up when the tide goes out.  Just my

hunch.

 

 

 

 

 

 

 

 

 

 

 

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Guest longinvestor

So now I plan to invest a chunk of the family portfolio in index funds—oh, the horror!—and put most of the rest into companies that should do at least okay no matter how the world changes. In other words, I’m buying the kinds of companies owned by Warren Buffett, who has long recommended owning stocks you’d be happy to hold even if the markets were closed for five years. But, as wise as that advice is, I generally ignored it because it would keep me out of stocks that could double in two years. No longer.

 

This guy's candor is to be appreciated. Especially publishing for Kiplinger magazine which I read when I'm waiting for a haircut etc.  You know,  "Top 10 stocks you must buy, now".

 

So, is this about failure due to concentration? Really? For grins, I googled Feinberg's past articles. He has expressed admiration for Buffett and closet indexing going back at least to 2005. For all I care he may have invested 50% buy-and-hold names and 50% index for all that time or longer! His own money! All this article says is that his clients said he was not worth the fees. He and his wife decided the anguish was not worth it. Perhaps this was why Buffett closed down the partnership and got into the job of pleasing folks without any expectations or strings. Lot more fun!  Still need to know what you are doing.

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I think the Buffett/Munger view of concentration has always been more of a philosophical view and not a practical one.  They've actually been really good a keeping a diversified portfolio for themselves on a "look-through" basis.  Buffett owns his home outright (paid cash), his Laguna Beach vacation home, kept a personal investment account outside of BRK, usually had generals, special-situations, cash, etc. until BRK was quite large.  Buffett has been a mult-millionaire outside of BRK for a really long time.  I think Charlie had money in real estate during the early days of BRK as well.

 

I think people need to be careful when listening to people that are multi-millionaires even if their entire stock portfolio would go to zero.  There is a big difference between someone with a $100M net worth putting 25% of their money in 1 stock and someone worth $100K putting 25% of their money in 1 stock.  Especially individuals like Warren/Charlie would either (a) are or (b) have influence over management.

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in my view, this guy has 2 problems, neither of which is concentration.

 

the first problem is his client base.  every great investor talks about how important your client base is.  to successfully run a concentrated portfolio, your clients have to understand that there is a good chance you will under-perform the markets for long periods of time.  even  munger had back to back -34% years.  if your clients are thinking month to month, you should fire them b/c they clearly don't understand how concentrated portfolios work.

 

the second problem is his inability to deal with volatility.  pabrai's wife has commented that she did not see a single change in mohnish's behavior in his personal life when the world was blowing up around him.  this guys wife was clearly not happy.  concentration can be extremely emotionally taxing.  every great investor has written about this at length.  you need to be able to just ignore the world.  this guy clearly couldn't.

 

these comments are not meant as criticisms.  very few people are built in such a way as to deal with the volatility that can come from a concentrated portfolio.  many of those who are built that way have become very very wealth.  many of those who thought they were, but learned they were not when the sht hit the fan have become poor and resorted to index funds.  there is no shame in that, but it is a shame they didn't just index from day 1.

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A lot of people think they know enough about a certain idea but really don't (myself included!). We fool ourselves because we fall prey to the same psychological misjudgments that we profess to know like the back of our hand.

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in my view, this guy has 2 problems, neither of which is concentration.

 

the first problem is his client base.  every great investor talks about how important your client base is.  to successfully run a concentrated portfolio, your clients have to understand that there is a good chance you will under-perform the markets for long periods of time.  even  munger had back to back -34% years.  if your clients are thinking month to month, you should fire them b/c they clearly don't understand how concentrated portfolios work.

 

the second problem is his inability to deal with volatility.  pabrai's wife has commented that she did not see a single change in mohnish's behavior in his personal life when the world was blowing up around him.  this guys wife was clearly not happy.  concentration can be extremely emotionally taxing.  every great investor has written about this at length.  you need to be able to just ignore the world.  this guy clearly couldn't.

 

these comments are not meant as criticisms.  very few people are built in such a way as to deal with the volatility that can come from a concentrated portfolio.  many of those who are built that way have become very very wealth.  many of those who thought they were, but learned they were not when the sht hit the fan have become poor and resorted to index funds.  there is no shame in that, but it is a shame they didn't just index from day 1.

 

While I agree with you that he certainly has the 2 problems you mentioned. I don't think you can argue against him that he has a good investment process and he will be a success. We don't know his portfolio except his ZINC and SUNE(?sp) blew up. You have to take his word for it that he made a mistake concentrating on his holdings........ I am assuming that a big chuck of his portfolio has suffered permanent loss of capital.

 

The hedge fund world is crowded now like the mutual fund world. And like mutual funds by definition the majority will lag the market esp. when they charge such steep fees.  So it is a fair assumption based on what he said and the normal that he is doing his customers a favour by leaving the industry.

 

 

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I guess I am one of these guys who seem to know less about investing than 20 years ago - all I have learned is humility and a healthy respect for Mr. Market. I am a diversified investor and typically have about 40 stocks in my portfolio. I did not find that my "best" ideas necessarily performed best in the past. I often had secondary ideas where I bought just a small position and those outperformed my best ones, (or those I considered best when I bought in).

I like to be diversified as an insurance against my lack of knowledge and more so against my hubris. Being diversified has advantages. I found for example that when I have large positions in a stock, my judgement tends to me less rational. i think what happens is that a large position becomes not only a matter of money, but also a matter or ego (you got to be right) and due to the large stake involved (both financial and emotionally) the decisions about buying and tend to be less rational than with smaller stakes. I view diversification as "cheap" insurance against blow ups ands keep sound sleep at night.

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I guess I am one of these guys who seem to know less about investing than 20 years ago - all I have learned is humility and a healthy respect for Mr. Market. I am a diversified investor and typically have about 40 stocks in my portfolio. I did not find that my "best" ideas necessarily performed best in the past. I often had secondary ideas where I bought just a small position and those outperformed my best ones, (or those I considered best when I bought in).

I like to be diversified as an insurance against my lack of knowledge and more so against my hubris. Being diversified has advantages. I found for example that when I have large positions in a stock, my judgement tends to me less rational. i think what happens is that a large position becomes not only a matter of money, but also a matter or ego (you got to be right) and due to the large stake involved (both financial and emotionally) the decisions about buying and tend to be less rational than with smaller stakes. I view diversification as "cheap" insurance against blow ups ands keep sound sleep at night.

 

Couldn't have said it better.

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One thought I have:

 

Imagine I did an analysis of oil majors in 2003-2004 and I picked CVX, great huh? I held till recently just before oil tanked. Brilliant?? I remind myself, I didn't know much about oil, and I could easily have picked BP!  So I remind myself that I could've been a screwup even when I succeed.

 

Same goes for FCAU, as I recall Pabrai has 40% position in his fund. But imagine.... for a sec.... if the emission scandal happened to FCAU instead of VW!  Nobody could've guessed such a thing could happen right? 

 

I don't think any analysis could have hinted at BP spill of VW emissions scandal....... it could have happened to any company..... so I feel it is reckless to put so much of one's money in a undiversified company.

Note that doesn't mean it is reckless to invest 40% in a Brk.

 

 

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So 3 of his top 5 holdings blew up. And the problem is concentration? Sounds like the real problem is picking the wrong stocks. If you are a poor investor and you concentrate, yes, you will lose your shirt.

 

Concentration has made all the difference to my investment returns over the past 20 years. Sometimes that has meant 100% cash; 80% Fairfax; 80% Apple etc. I do not look to get concentrated; however, if Mr Market drives the price low enough I am happy to back up the truck for short periods of time.

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Kind of off-topic: I'm currently reading Damn Right! (biography about Charlie Munger) and at one point his partnership was 60% invested in Blue Chip Stamps--didn't realize he was THAT concentrated. The partnership's returns were great for the ~13 years he ran it but it wasn't a smooth ride. He had two years of 70% growth and two years of 30% losses. Anyway, I don't have much of a point, just thought of this thread while reading the chapter earlier.

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So 3 of his top 5 holdings blew up. And the problem is concentration? Sounds like the real problem is picking the wrong stocks. If you are a poor investor and you concentrate, yes, you will lose your shirt.

 

When I read the article that was my first thought, maybe he wasn't very good. Maybe he just burned out like some people do or the stress of short sighted clients combined with stress at home had an impact at work.

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