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Portfolio Concentration


Viking
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I have been thinking about portfolio concentration for many years. On the one side of the fence is the investment industry that requires/advises a portfolio to be diversified in 15 or more stocks, bonds etc. On the other side of the fence are many small business owners who may have their entire net worth tied up in one business (the business they own). There is also the middle ground; Buffett has talked about how 6 decisions over a lifetime can make an inverstor very successful; once you find a great opportunity ‘back up the truck’ (concentrate your portfolio).

 

Let’s take two scenarios:

1.) Small business owner who’s entire net worth is tied up in their business (let’s assume the business is the average business in the small business universe)

2.) Investor whose entire portfolio consists of Berkshire Hathaway

 

Which choice carries more ‘risk’ to the investor?

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You have your choice of meals

 

1) Dish A prepared by a chef at a small local restaurant.

 

2) A Delmonico steak from Delmonico’s in NYC.

 

Which is more risky?

 

Of course #1 is more risky, you aren’t even telling me what it is.

 

A small businessman has the potential to make a lot more from his initial investment by investing his time and money into his business, but it is certainly more risky than just sitting back and being a passive investor in BRK.

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Great post - I’ve been thinking of the same. After completing my MBA and studying healthcare and investing for two years, I find myself with a very small circle of competence in my area of expertise in a subspecialty of medicine, barely. So I can either concentrate and know what I’m doing, or diversify. I’ve chosen the former and that too in micro and small cap companies (only 2 so far where the initial investment thesis was not disconfirmed), where I have a reasonable idea of their business model, story, valuation and teams. It is def a roller coaster, one has gone from a share price of $3.50 to 27 to 10 over the last year!

 

Time will tell, but imho wealth is created by concentrating in good ideas, as long as you don’t lose money doing so. Otherwise what’s your edge over simply indexing (when valuations are reasonable)

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I have been thinking about this as well.  I don't know about going all in on just one stock but I have found it very tough to build a diversified portfolio that can beat the market.  I have cut back to only 5 or 6 investments over the past couple years, for me that's quite concentrated.  I hold roughly half of my portfolio in index funds and half spread across this small group of investments.  My goal is to get those 5 or 6 companies down to 3 or 4.  There just aren't that many good opportunities out there so even with 5 or 6 I am compromising.

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Time will tell, but imho wealth is created by concentrating in good ideas, as long as you don’t lose money doing so. Otherwise what’s your edge over simply indexing (when valuations are reasonable)

 

Many have had phenomenal returns with a large portfolio.  Lynch owned on the order of hundred(s) of stocks and he killed the index. So did Schloss.  Even buffett had around 100 holdings in the 60's.

 

I think concentration on half dozen stocks should absolutely be value plays. That is they should be sure bets on undervalued assets -- not earnings.

 

 

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I think for an individual without a team of analysts and limited resources, concentration makes absolute sense. Of the opportunities that I can look at due to time, a small percent I can understand, and a small percent of those are actually good values after I go through the analysis. To me it makes sense that if I work at it I can find 1-2 good ideas a year, but 20 or 30? no way.

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I prefer a concentrated approach, it's just extremely important to consider the downside in those cases. I think the best opportunities I've come across has been good/decent biz facing temporary headwinds combined with an extremely strong balance sheet. Thus you might get a combination sales growth and increased margins, which the market usually re-rates much higher, and worst case you don't lose much.

 

SMA Solar has been one of those cases for me (twice now). Went from 12 to 50 in a couple of months and with 60-70 pct. of the market cap in cash downside was fairly well protected. Then it went to 20 and back to 40 not long after. I didn't make nearly as much as I should have, because I didn't concentrate enough, but I think those cases (if you think management is aligned) is where it really makes sense to go big. Not when a debt-fueled, price-gouging pharma-rollup is shooting towards the stars.

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Time will tell, but imho wealth is created by concentrating in good ideas, as long as you don’t lose money doing so. Otherwise what’s your edge over simply indexing (when valuations are reasonable)

 

Many have had phenomenal returns with a large portfolio.  Lynch owned on the order of hundred(s) of stocks and he killed the index. So did Schloss.  Even buffett had around 100 holdings in the 60's.

 

I think concentration on half dozen stocks should absolutely be value plays. That is they should be sure bets on undervalued assets -- not earnings.

 

You’re right, everyone has to have their own investment philosophy and it can be concentrated or diversified. Personally, I’ve only found 3 ideas in 3 years despite looking and have not been able to diversify (Goal is 5-15 total investments). If valuation is from growth assets rather than current assets, then a much bigger margin of safety than 25% is desirable, more like 50% plus  - if there is more risk, one has to be sure to be adequately compensated for that higher risk.

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I think without question the bigger risk is with the guy running his own business. Plain and simple, if the guy loses his business, he loses everything. If one loses his portfolio, he would still typically have his job which provides income. Add in the current environment in which big box retailers and online shopping are annihilating most small, main street businesses, and personally I think it's a tough sell to take on the risk of being a small business owner right now unless you are very well financially situated.

 

As for portfolio concentration, I think it's optimal to own a lot but be concentrated in very few, high quality opportunities. For instance I have investments in 20-30 different companies/products. However about 70%of my portfolio is invested in 3 companies. I think it was Bruce Berkowitz who said something along the lines of "diversification will just lead to average results" and that "only a couple great ideas can make a big difference in one's life". I think both are pretty accurate and good to remember.

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Thanks to everyone who have shared their thoughts... great to get lots of different perspectives.

 

My experience is every couple of years I will get an opportunity that, from my perspective, is very high probability (80%) of going up 50-100% in a couple of years. These ideas are typically very big companies. One example was Apple when it fell to $60 about 4 or 5 years ago. A second example was the big US banks starting about two years ago. I am comfortable going with a very high concentration (sometimes 100% for 6-12 months). People tell me I need to diversify my portfolio. The problem is I do not have other ideas I feel will come close to making the same high probability return.

 

I did the same thing with FFH (high concentration) a number of times in 2003-2010 back when its price was being driven all over the place when it was listed on the NYSE.

 

I am trying to reconcile in my mind how being 100% invested in Apple or BAC for 12-36 months (buying when they are out of favour and the stock is selling dirt cheap) is more risky than the many people whose net worth is tied up in a small business.

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We're in the concentrated camp, and typically hold just 1 company per circle of competence - same as the small business person.

 

Every small business person we've ever met tries to hedge their intrinsic risk - but risk management execution expertise is very limited. Most use property, some use investment in other businesses, but almost nobody uses cash/t-bills or long term sovereign bonds/gilts.  As risk management execution is in our circle of expertise, we have the luxury of being able to do it in reverse.

 

We have also broadened 'circle of competence' to now include 'long term thesis' (estate planning kicking in).

We have adopted the 50 year view that Newfoundland will benefit from global warming, and the opening of the NE and NW sea passages to Asia, much as Aberdeen and Scotland have benefited from the development of their off-shore oil fields. Panama traffic shifting northwards, Newfoundland resources going west (oil, iron, fish, removal of land locks, etc.), opening of new resources as Labrador melts. Execution via passive investment ranging from housing through to resource investment through to technology creation. Beneficiaries being today's and future grand kids.

 

Newfoundland vs BC?

Newfoundland doesn't have the earthquake risk of possibly falling into the ocean tomorrow, and it's a rare 'newfie' who cannot talk his/her way out of trouble via the 'gift of the gab'. Hopefully it works out well for us.

 

SD

 

 

 

   

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For Viking and those others who concentrate, do you mind indicating what your portfolio size is relative to your current annual savings rate?  E.g. 15 years of savings.  I don't want to disclose too much but I am say greater than 10 x of annual savings.

 

Up to the value of a modest 3 BR house in our area, per circle of comptence. After that we start to sell down & return capital.

 

SD

 

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To go back to the core small business / single security debate.  One of the advantages to securities is that you can fractionally own them, this is much harder with a small business.  By going 100% on a single stock I think you are losing out on this advantage.  I can't help thinking that you should be able to find 2 stocks.  Maybe go 60/40 if one is better odds.  Even with berkshire which is perhaps the safest company on the planet , you just never know.  Some legal issue or unforeseen event can always take it down.  Live to fight another day, the way I see it.  If you can find stocks with 100% upside, then you will be able to make it back. Even if you lose half your money on a bad stock pick it will just set you back a couple years until the other stock pays off. 

 

I think again it really comes down to the amount of time it would take to rebuild your portfolio, then adjusted for your age.  There is a certain point where going all in on one stock just doesn't make sense, in my opinion.  Regardless of the potential return.

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For Viking and those others who concentrate, do you mind indicating what your portfolio size is relative to your current annual savings rate?  E.g. 15 years of savings.  I don't want to disclose too much but I am say greater than 10 x of annual savings.

 

My portfolio is large enough that I do not have a day job (I tell people that I am a financial planner with just one client). As my portfolio grows in total value my thinking is starting to shift a little from total return to preservation of capital.

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Guest cherzeca

if you want to create wealth, concentrate.  if you want to preserve wealth, diversify.

 

or do both:  hold large cash position and a few names you like a lot.  i say cash because i am short long term credit.  if rates were higher, substitute credit for cash.

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if you want to create wealth, concentrate.  if you want to preserve wealth, diversify.

 

 

Well said! This is the risk variance graph from our corporate finance textbook - as you can see, after 5 stocks the slope of the curve flattens quite a bit; after 20 not much difference on adding the 21st

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Core to concentration is recognition that you are riding market cycles (macro tides), rather that names (boats on the tide). It's much less about selecting the best stock (boat), and more about knowing how to read a tide table (macro projection).

 

Diversification is only useful if you are investing in the tides at different places. If you're just investing in different boats on the same tide, at the same place, it's pretty useless. Hence either truly diversify, or don't do it at all - there is no in between.

 

SD

 

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if you want to create wealth, concentrate.  if you want to preserve wealth, diversify.

 

 

Well said! This is the risk variance graph from our corporate finance textbook - as you can see, after 5 stocks the slope of the curve flattens quite a bit; after 20 not much difference on adding the 21st

I think that graph is probably a bit deceptive. One portfolio of 20 stocks isn't going to behalve the same as another portfolio of 20 stocks. I guess here they averaged the results of multiple portfolio's (?) so you don't see the variance of the variance. And most investors don't buy portfolio's of random stocks; they buy something with a common theme because they think those are a good deal. Perhaps they focus on bank stocks, perhaps low P/B stocks, perhaps it's growth; whatever it is, you can be sure it will be more correlated and the portfolio will not behave like that graph.

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To go back to the core small business / single security debate.  One of the advantages to securities is that you can fractionally own them, this is much harder with a small business.  By going 100% on a single stock I think you are losing out on this advantage.  I can't help thinking that you should be able to find 2 stocks.  Maybe go 60/40 if one is better odds.  Even with berkshire which is perhaps the safest company on the planet , you just never know.  Some legal issue or unforeseen event can always take it down.  Live to fight another day, the way I see it.  If you can find stocks with 100% upside, then you will be able to make it back. Even if you lose half your money on a bad stock pick it will just set you back a couple years until the other stock pays off. 

 

I think again it really comes down to the amount of time it would take to rebuild your portfolio, then adjusted for your age.  There is a certain point where going all in on one stock just doesn't make sense, in my opinion.  Regardless of the potential return.

 

Totally agree with everything you mention in this post. I try to hold 20 stocks if I can find 20 good ones, but if I can only find 4 at certain times then I will concentrate heavily in those or hold some cash, but I think what's written above is very sensible.

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  • 2 months later...

#1 is higher reward. Buffet is a bit disingenious when on CNBC he says don't use leverage because you can get rich slow and don't risk what you need for what you don't. I mean reading that I'm thinking, you need the carry cost - your rent and living expenses. It won't work if you don't have the day job, or enough capital to slowly sell down . The guy had a safety net and investment partners and a salary so of course he could think no leverage.

You could do #2 on leverage...it might be better than #1 and crash and burn. But the reward of #1 can be so large. Why not a mix of #1 and #2?

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