The beauty of a concentrated portfolio.
How to fight the all-you-can-eat-mentality and compound returns.
I love buffets. I enjoy being fully immersed in culinary variety and savouring the freedom to pick just the food items I want.
I usually take my time, carefully considering possible combinations. Occasionally, some random person with a massive pile of food cuts in front of me to grab more lasagna.
Another victim of all-you-can-eat-mentality. We are all continuously pressured into thinking that more is better. We keep stacking food on our plates, but all that mixing won’t taste good. More importantly, we give up the pleasure of choosing a suitable dish for ourselves.
This attitude could be hazardous in investing. We call for trouble if we start to think of stocks as something to keep amassing on our plate without any conviction behind our choice. Excessive diversification is what Peter Lynch called “diworsification”.
We have all heard that 99% of people should invest in a well-diversified low-cost ETF. Just keep buying SPY, let it do its thing, and before you know it, you are a millionaire. It’s a reasonable approach, but it’s important to remember that this investment strategy will only produce average returns. Don’t get me wrong; average returns can make you very rich over the years. Still, many investors aspire to something more than average. I certainly do.
Now, here is the thing….
It is a common idea in finance that diversification is a way to control risk. This assumption is very debatable. By diversifying, you keep stacking up stocks. You ultimately hope that some outliers will outperform, making up for all the bad stocks in the portfolio. I find this approach much riskier. I’m exposing myself to the significant risk of watering down my returns while still being exposed to Mr Market’s temper. My risk/return ratio is skewed in the wrong direction.
Ignorance is the real risk in investing, and excessive diversification is a product of ignorance.
As Warren Buffet said, “Once you are in the business of evaluating businesses, and you are up to dedicate the intensity and time required to get that job done, diversification is a terrible mistake.”
You have to be willing to put the time into research and understand what you are investing in. You have to LOVE what you buy!
When I buy a stock, I’m buying a business. I stay focused, and I take the time to research and understand what I’m buying. Having fewer stocks in my portfolio allows me to understand them better. I genuinely believe that a highly concentrated portfolio backed by extensive research is less risky and provides superior returns.
Depending on who you ask, diversification or concentration can mean different things. A portfolio should hold at least 80 stocks for some financial advisors. On the other hand, a 5 to 15 stocks portfolio would be considered highly concentrated. Keep in mind that super investors like Nick Sleep or Monish Pabrai, in the past, have happily held a portfolio of only three stocks!
Sadly we are not Monish Pabrai, so perhaps we should not try to do what he does. Instead, we should do what we can commit to. Suppose we have no ability or inclination to spend countless weeks reading 10ks and projecting future free cash flow. In that case, we should stay away from portfolio concentration and happily embrace the average of diversification.
Running a concentrated portfolio requires true conviction to survive the inevitable volatility. The portfolio could experience big swings. It is a volatile approach, but it can produce incredible compounded returns.
I run a carefully constructed ten by ten portfolio. Ten positions, with a max of 10% of my stake invested in every position. It works for me, but you have to figure out what works for you.
Next time you pick stocks, remember to slow down, enjoy the power of choosing, and stop amassing your plate with food for the love of God.
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