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What is a concentrated portfolio?


bennycx
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Hi,

 

Members on this board tend to say they hold a concentrated portfolio or position, but what do you mean by that? I hold a ~half a mil portfolio with 2 stocks making up 75% of it and the rest in cash and I think that is concentrated. However there are members also saying they have concentrated positions and subsequently reveal their top position to be ~10-15%. I understand if you have a 10 mil portfolio but is everyone a multi-millionaire here? I think this portfolio allocation is pretty diversified and many high net worth investors I know run 10-20 positions as a norm.

 

WEB and Munger has said that if they were to run small amounts of capital, they would pick only 4-6 high conviction stocks and hold them for a period of time, and certainty DJCO is run that way.

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Probably worth considering that "concentrated" is relative to most money managers with no position being greater than a couple of percentage points.

 

Anyhow, I would say a concentrated portfolio is one that 80% of the allocation is 6 stocks or less, or something around there. 

 

I would use an extra label for more concentration than that--"super concentrated" or something like that.  e.g., I have a super concentrated IRA where I'm usually at 3-4 positions for the whole portfolio.

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I look at it two ways:

1) A diversified portfolio is one which eliminates systematic risk.

 

I read somewhere that ~30 positions remove something like 95% of systematic risk.

 

From that perspective I would say that anything under 30 positions is "not-diversified"

 

2) What is the amount of stocks to own, that if equally weighted, a permanent loss of capital in one position would have a meaningful effect on the overall portfolio. For me that is about 10 positions.

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Well if you have 2 positions that make up 75% of the portfolio you're definitely running a concentrated portfolio.

 

There's no hard rule of what constitutes a concentrated portfolio. But generally of there if your top 7 positions make up more than 50% of the portfolio they'd say you're running a concentrated portfolio.

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Probably worth considering that "concentrated" is relative to most money managers with no position being greater than a couple of percentage points.

 

Anyhow, I would say a concentrated portfolio is one that 80% of the allocation is 6 stocks or less, or something around there. 

 

I would use an extra label for more concentration than that--"super concentrated" or something like that.  e.g., I have a super concentrated IRA where I'm usually at 3-4 positions for the whole portfolio.

 

As racemize says, I think this is generally discussed with reference to an average portfolio.  I have seen mutual funds say things like: we think financials will outperform, so we have overweighted our exposure to financials to 8% versus a 6% weighting in the index.  That's simply not going to move the needle.

 

A concentrated portfolio has positions that will move the needle.  The 2 stock portfolio mentioned to start the portfolio is definitely super-concentrated.  Certainly too concentrated for my personal taste.

 

If someone has 50% of the portfolio in 5 names, that is something where: (1) those performance of those individual stocks makes a difference to the portfolio; and (2) the portfolio can significantly diverge from the index.

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I usually run 5-10, 6 currently.

 

What do you own that you have such a large position in besides brk?

 

Previously I had 55% WFC 25% BAC and 20% AXP and I sold away my BAC.. I take comfort in the fact that I have an income which will probably add 10-20% extra cash to the portfolio each year. Certainly if I did not have a job, I would diversify more but don't think I'll go beyond 5-8 stocks. I feel that I know those stocks well enough to understand they're a low risk bet. If there is a decent probability of a stock having a permanent impairment of capital, I feel it makes sense to not even invest, rather than buy a lot of them to diversify.

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I usually run 5-10, 6 currently.

 

What do you own that you have such a large position in besides brk?

 

Previously I had 55% WFC 25% BAC and 20% AXP and I sold away my BAC.. I take comfort in the fact that I have an income which will probably add 10-20% extra cash to the portfolio each year. Certainly if I did not have a job, I would diversify more but don't think I'll go beyond 5-8 stocks. I feel that I know those stocks well enough to understand they're a low risk bet. If there is a decent probability of a stock having a permanent impairment of capital, I feel it makes sense to not even invest, rather than buy a lot of them to diversify.

 

Don't you think you overestimate your own ability to determine the risk of permanent impairment of capital?

 

To be honest I think all your holdings have such a risk as all of their businesses would be significantly impacted by a major event in the financial markets (e.g.  a major currency blow up, bank runs, large systematic defaults, a black swan such as exponential cryptocurrency adoption). These events have a non-zero chance of occuring. On top of this all your holdings are vulnerable to the same sort of event!

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I usually run 5-10, 6 currently.

 

What do you own that you have such a large position in besides brk?

 

Previously I had 55% WFC 25% BAC and 20% AXP and I sold away my BAC.. I take comfort in the fact that I have an income which will probably add 10-20% extra cash to the portfolio each year. Certainly if I did not have a job, I would diversify more but don't think I'll go beyond 5-8 stocks. I feel that I know those stocks well enough to understand they're a low risk bet. If there is a decent probability of a stock having a permanent impairment of capital, I feel it makes sense to not even invest, rather than buy a lot of them to diversify.

 

Don't you think you overestimate your own ability to determine the risk of permanent impairment of capital?

 

To be honest I think all your holdings have such a risk as all of their businesses would be significantly impacted by a major event in the financial markets (e.g.  a major currency blow up, bank runs, large systematic defaults, a black swan such as exponential cryptocurrency adoption). These events have a non-zero chance of occuring. On top of this all your holdings are vulnerable to the same sort of event!

 

I was thinking along the same lines.  It is okay to take a gamble if you can contribute 20% per year but don't kid yourself on the risk you are taking here.  With WFC, I just wonder if that really is the best pick out there right now?  Not that it's a bad investment but if I ranked stocks I think there are others with as good risk/reward or close enough that I wouldn't be able to assign such higher weight to WFC.

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I usually run 5-10, 6 currently.

 

What do you own that you have such a large position in besides brk?

 

Previously I had 55% WFC 25% BAC and 20% AXP and I sold away my BAC.. I take comfort in the fact that I have an income which will probably add 10-20% extra cash to the portfolio each year. Certainly if I did not have a job, I would diversify more but don't think I'll go beyond 5-8 stocks. I feel that I know those stocks well enough to understand they're a low risk bet. If there is a decent probability of a stock having a permanent impairment of capital, I feel it makes sense to not even invest, rather than buy a lot of them to diversify.

 

Don't you think you overestimate your own ability to determine the risk of permanent impairment of capital?

 

To be honest I think all your holdings have such a risk as all of their businesses would be significantly impacted by a major event in the financial markets (e.g.  a major currency blow up, bank runs, large systematic defaults, a black swan such as exponential cryptocurrency adoption). These events have a non-zero chance of occuring. On top of this all your holdings are vulnerable to the same sort of event!

 

 

Okay, I'll play along (because I too am unwisely concentrated).  If a systemic event adversely affected WFC, BAC and AXP to the point that there were a meaningful permanent loss of capital, what else would likely be occurring in the broader economy and society?  I fully concur that there are a number of systemic events that could take out all three companies, but I would assert that it would likely be accompanied by a debauching of the currency and general collapse of the economy, for which gold bullion, canned food and adequate ammunition supplies are the only realistic hedge.

 

Food for thought.

 

SJ

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Concentration can also be vertical instead of horizontal. E.g. if you own 100% Berkshire, it may not be diversified in terms of stocks but it certainly is very diversified in terms of what you own and adding even more stocks may be quite unconcentrated. Another example might be something like the former TCI if you could know their plan. 1 stock and now you got like 20? stocks in your portfolio from the children that were spun-off.

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[

 

 

Okay, I'll play along (because I too am unwisely concentrated).  If a systemic event adversely affected WFC, BAC and AXP to the point that there were a meaningful permanent loss of capital, what else would likely be occurring in the broader economy and society?  I fully concur that there are a number of systemic events that could take out all three companies, but I would assert that it would likely be accompanied by a debauching of the currency and general collapse of the economy, for which gold bullion, canned food and adequate ammunition supplies are the only realistic hedge.

 

Food for thought.

 

SJ

 

I believe the circumstances that one finds oneself in play a large role in what level of concentration is "appropriate". This is something I do not believe this board spends enough time on.

 

For example---someone who is in the early stages of a solid career  that provides surplus cash flow (above living expenses) is likely more able to work through even an extended significant decline in their portfolio. Whereas someone that is living off what their portfolio provides perhaps cannot.

 

Also---the whole discussion of the risk of a permanent loss being the only potential risk of a concentrated portfolio (SJ---not implying you said this) is also overly simplistic. There are many real life examples where a large albeit temporary decline in the value of investments would cause great pain (e.g., in a divorce settlement where the higher value at separation day is used to determine payout at the divorce).

 

Basically the point I am trying to make is that the level of portfolio concentration that one should consider is very much  dependant on their own circumstances. No one size fits all and I would caution all those who blindly believe that a concentration portfolio is the only way to go should re-examine this issue in light of their own circumstances. I suspect that in most cases a more diversified portfolio would be the result.

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I think the idea that you can avoid companies that present the risk of permanent loss of capital merely by selecting stocks carefully is wrong.

 

Some quick examples:

 

(1) Volkswagen.  There was no way for an outside investor to know about the emissions issue.

(2) Lumber Liquidators.  60 Minutes?

(3) VRX.  I know there was a lot of skepticism about the stock before it fell, but a lot of intelligent investors were shareholders.

(4) Theranos.  Not public, but again a lot of smart investors drawn in.

 

There is a long list.  Some of these are simply unknowable events for individual companies.  Don't think they are avoidable.  Some are investor error or have an element of investor error.  Perhaps avoidable, but I don't know that someone can count on never making such an error.

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We routinely use a concentrated portfolio approach, & would add 3 explicit considerations.

 

If you work in an industry (or are relying on a pension from it); and are investing in that industry that you know (equities &/or FI) - you need to realize that you are extremely concentrated. Worse still is that if you are also reliant upon employment income from that industry to pay your mortgage (most people) - you've also leveraged this industry exposure by your mortgage/house equity. Lose your job to an industry downturn, and you will lose your income at the same time your investments crater, & possibly your house as well.

 

If you are this person & you have a big mortgage - you want a bearish portfolio (shorts or puts). When the sh1t happens you want the portfolio value to rise, AND you want to be able to sell enough to reduce your mortgage to 50% - to eliminate the industry leverage. Hence you're looking at the size of your mortgage, the cyclicality of your industry, the competitors in your industry, & trying to figure out which ones will hurt the most in the next downturn. Ideally it's not a firm you work for.   

 

If you've done well the mortgage is paid off, & a portion of your portfolio is in FI.

Apply moderate margin, put it into your 2 best picks, & systematically sell on runs & falls; to gain on BOTH the up & down cycles.

 

Looking for a 'formula' isn't going to help you.

Applying what you know, will.

 

SD

 

   

 

 

 

 

 

   

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I think the idea that you can avoid companies that present the risk of permanent loss of capital merely by selecting stocks carefully is wrong.

 

Some quick examples:

 

(1) Volkswagen.  There was no way for an outside investor to know about the emissions issue.

(2) Lumber Liquidators.  60 Minutes?

(3) VRX.  I know there was a lot of skepticism about the stock before it fell, but a lot of intelligent investors were shareholders.

(4) Theranos.  Not public, but again a lot of smart investors drawn in.

 

There is a long list.  Some of these are simply unknowable events for individual companies.  Don't think they are avoidable.  Some are investor error or have an element of investor error.  Perhaps avoidable, but I don't know that someone can count on never making such an error.

 

Well said.  I have been caught once or twice or three or four times..... 

 

These days I hold about 15 stocks. 

By industry:

20% financial: FN, RY

25% energy providers/transmitters: ENB, AQN, BEP.un

20% oil and gas: BTE, WCP, PWT

20% service/suppliers: Rus; MTL

Other: BCE, a couple of prefs. 

 

Notice its almost all Canadian at least where they are listed. 

 

Since I live on this income I need to keep reasonably diversified.  I had SSW blowup this year and that reminded me why I diverisfy. 

 

In the old days when a complete blowup would only cost me a years pay I would be much more concentrated.  As per  Bearprowlers comments alot depends on situation.

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I think the idea that you can avoid companies that present the risk of permanent loss of capital merely by selecting stocks carefully is wrong.

 

Some quick examples:

 

(1) Volkswagen.  There was no way for an outside investor to know about the emissions issue.

(2) Lumber Liquidators.  60 Minutes?

(3) VRX.  I know there was a lot of skepticism about the stock before it fell, but a lot of intelligent investors were shareholders.

(4) Theranos.  Not public, but again a lot of smart investors drawn in.

 

Stevie,

 

I don't actually (necessarily) dispute your thesis, but your examples here are ... no good.

 

#1 - Emissions details were out there >1 year before the stock tanked.  Many didn't see it, but if you had >25% of your net worth in VW, I think you could have / would have done the work.

 

#2 - I didn't follow this one closely, but weren't the negatives about this company outed by short sellers many months in advance?

 

#3 - This is clearly a terrible example.  The burden of proof was on VRX longs... anyone concentrated in this name was simply believing in ferries.  there is clearly a difference in believing something may be a game changer and owning a 3% position, vs. betting that it is in fact most certainly a game changer and betting huge.  Anyone betting huge on VRX was clearly wrong on many levels as it was a high debt company, with GAAP losses, and shady characters all over.  This isn't even hind sight.

 

#4 - Hard to say, but did anyone other E Holmes actually make a concentrated bet?  They only raised $700m I think in total.  I get that it was valued at like $10B, but no one made this a concentrated position to my knowledge except for maybe some employees.

 

I would also add, "lot of smart people" getting pulled into a story isn't a good rationale to say why concentrated investing doesn't work.  It's a good way to say:

 

1) Many people who seem smart, aren't

2) For most mere mortals, investing is really hard, betting big is dangerous, and you better do your own work - and not be wrong.

 

My 2 cents.

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In the VW case the key question is: do you think you are one of the wizards who could've foreseen the emission scandal before the stock cratered? As for myself, I wouldn't bet my portfolio on it. I agree that the others are bad examples. Especially Valeant was clearly a case of 'caveat emptor'. The VRX topic on this forum even opened with the question "Is this a fraud?" ..

 

p.s.: Valeant was clearly the Titanic among ferries.

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A little expansion on the leverage ...  assume that you own a house in the oil patch (Calgary/Edmonton), work in the industry, and need your employment income to pay your mortgage.

 

If your house is worth 100K, & you have a 80K mortgage; your industry leverage is 4x - and very high [80K mortgage/(100K house value - 80K mortgage)]. To lower your leverage you need 1) a non recourse mortgage (US only), 2) house appreciation, or 3) less mortgage.

 

A mortgage at 50% of house value produces a leverage of 1x. As the intent is risk management, most would reduce the mortgage to 40% in anticipation of a simultaneous 20% reduction in the value of the property (ie: everyone selling up at the same time, & looking for work elsewhere). Hence the first $ of any taxable savings should really be invested in accelerated mortgage repayment - until it gets to about 40% of house value.

 

Assuming conservatism, at a mortgage of 5%, the ratio is 0.07 (5/(80-5) - indicating you would benefit from a downturn. As you anticipate a 20% decline in house value, the benefit is 50% of the lower house value - existing mortgage = .5(80)-5 = 35K. If you felt reasonably secure in your employment you would have 35K of equity, per 100K of house, to invest in your industry; when equity prices are at rock bottom. When the cycle turns, you will be well rewarded.

 

Just keep in mind that your portfolio is now a continuous hedge against the cyclicality of the industry you work in, & that you need to periodically keep taking capital out of the portfolio as it grows (to avoid hubris). Most would diversify the capital withdrawal into either life changing opportunities, or real estate unaffected by their industries economics.

 

It works very well.

 

SD

 

 

We routinely use a concentrated portfolio approach, & would add 3 explicit considerations.

 

If you work in an industry (or are relying on a pension from it); and are investing in that industry that you know (equities &/or FI) - you need to realize that you are extremely concentrated. Worse still is that if you are also reliant upon employment income from that industry to pay your mortgage (most people) - you've also leveraged this industry exposure by your mortgage/house equity. Lose your job to an industry downturn, and you will lose your income at the same time your investments crater, & possibly your house as well.

 

If you are this person & you have a big mortgage - you want a bearish portfolio (shorts or puts). When the sh1t happens you want the portfolio value to rise, AND you want to be able to sell enough to reduce your mortgage to 50% - to eliminate the industry leverage. Hence you're looking at the size of your mortgage, the cyclicality of your industry, the competitors in your industry, & trying to figure out which ones will hurt the most in the next downturn. Ideally it's not a firm you work for.   

 

If you've done well the mortgage is paid off, & a portion of your portfolio is in FI.

Apply moderate margin, put it into your 2 best picks, & systematically sell on runs & falls; to gain on BOTH the up & down cycles.

 

Looking for a 'formula' isn't going to help you.

Applying what you know, will.

 

SD

 

   

 

 

 

 

 

 

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I used to be concentrated but never making that mistake again! The only one I might consider is Berkshire.

The problem is actually not so much the concentration as the risk that your choice is worse than you think. Of course as your skill level and though process improve as to stock selection and pricing, the less you can diversify. It's almost an axiom that this accelerated wisdom comes from a huge loss though. Without a big mistake, I've found few catalysts to actually "getting it".

Right now I hold about 10-12 positions but Berkshire is the biggest one. As I learn more, I slowly rotate out of Berkshire and into these smaller holdings. I'm comfortable with 8-12 positions but not much less or much more. I also look for 1 or 2 arbitrage opportunities per year.

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A little expansion on the leverage ...  assume that you own a house in the oil patch (Calgary/Edmonton), work in the industry, and need your employment income to pay your mortgage.

 

If your house is worth 100K, & you have a 80K mortgage; your industry leverage is 4x - and very high [80K mortgage/(100K house value - 80K mortgage)]. To lower your leverage you need 1) a non recourse mortgage (US only), 2) house appreciation, or 3) less mortgage.

 

A mortgage at 50% of house value produces a leverage of 1x. As the intent is risk management, most would reduce the mortgage to 40% in anticipation of a simultaneous 20% reduction in the value of the property (ie: everyone selling up at the same time, & looking for work elsewhere). Hence the first $ of any taxable savings should really be invested in accelerated mortgage repayment - until it gets to about 40% of house value.

 

Assuming conservatism, at a mortgage of 5%, the ratio is 0.07 (5/(80-5) - indicating you would benefit from a downturn. As you anticipate a 20% decline in house value, the benefit is 50% of the lower house value - existing mortgage = .5(80)-5 = 35K. If you felt reasonably secure in your employment you would have 35K of equity, per 100K of house, to invest in your industry; when equity prices are at rock bottom. When the cycle turns, you will be well rewarded.

 

Just keep in mind that your portfolio is now a continuous hedge against the cyclicality of the industry you work in, & that you need to periodically keep taking capital out of the portfolio as it grows (to avoid hubris). Most would diversify the capital withdrawal into either life changing opportunities, or real estate unaffected by their industries economics.

 

It works very well.

 

SD

 

 

We routinely use a concentrated portfolio approach, & would add 3 explicit considerations.

 

If you work in an industry (or are relying on a pension from it); and are investing in that industry that you know (equities &/or FI) - you need to realize that you are extremely concentrated. Worse still is that if you are also reliant upon employment income from that industry to pay your mortgage (most people) - you've also leveraged this industry exposure by your mortgage/house equity. Lose your job to an industry downturn, and you will lose your income at the same time your investments crater, & possibly your house as well.

 

If you are this person & you have a big mortgage - you want a bearish portfolio (shorts or puts). When the sh1t happens you want the portfolio value to rise, AND you want to be able to sell enough to reduce your mortgage to 50% - to eliminate the industry leverage. Hence you're looking at the size of your mortgage, the cyclicality of your industry, the competitors in your industry, & trying to figure out which ones will hurt the most in the next downturn. Ideally it's not a firm you work for.   

 

If you've done well the mortgage is paid off, & a portion of your portfolio is in FI.

Apply moderate margin, put it into your 2 best picks, & systematically sell on runs & falls; to gain on BOTH the up & down cycles.

 

Looking for a 'formula' isn't going to help you.

Applying what you know, will.

 

SD

 

   

 

 

 

 

 

 

 

Real good posts, SD

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With respect to the home, it seems that the better approach would be to load up the house up to the roof with debt, and if an adverse event occurs that lowers the value of your home, you just put it back to the lender.

 

You keep a cash pile on the side and invest a good part of it conservatively. The investment return should beat the interest cost of the mortgage. At least in the US, where mortgage interest cost is deductible and mortgages are non-recourse, that seems to be a better approach.

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At least in the US, where mortgage interest cost is deductible and mortgages are non-recourse, that seems to be a better approach.

 

Non-Recourse States

 

Alaska

Arizona

California

Connecticut

Idaho

Minnesota

Montana

Nevada

North Carolina

North Dakota

Oregon

Utah

Washington

 

Recourse States

 

Alabama

Arkansas

Colorado

Delaware

District of Columbia

Florida

Georgia

Hawaii

Illinois

Iowa

Indiana

Kansas

Kentucky

Louisiana

Maine

Maryland

Massachusetts

Michigan

Mississippi

Missouri

Ohio

Nebraska

New Hampshire

New Jersey

New Mexico

New York

Oklahoma

Pennsylvania

Puerto Rico

Rhode Island

South Carolina

South Dakota

Tennessee

Texas

Vermont

Virginia

West Virginia

Wisconsin

Wyoming

 

http://www.forecloseddreams.com/recourse_states.html

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