One of the most difficult aspects of value investing is finding a particular investment philosophy and sticking to it for the long run. One of the inherent problems with using a long-term value investing strategy is the inability to evaluate the effectiveness of the strategy over shorter periods of time. Rather, an investor must rely on the assumption the strategy will be successful over long periods of time, even when the performance of the strategy has been lackluster in the short term. Thus, in order for a value approach to be successful, one must have the discipline and full commitment to the approach. However, it’s difficult to commit to any approach for the long-term when there is uncertainty surrounding the effectiveness of the approach.
In addition, the fact that we are putting wealth at risk by using an uncertain strategy that must be committed to for a minimum of 7-10 years is mentally troublesome. If the strategy does not perform well for the first 10 years in comparison to other strategies, certainly one would have been better off using another strategy. This is the risk one has to be willing to take. Investing success is therefore, not only reliant on the validity of our philosophy, but also the conviction and discipline to stick to the philosophy over time.
Luckily an investor has the ability to learn from the best value investors of all time when building the foundation of our own investment philosophy. While each of us adhering to a value investing strategy has our own unique philosophy, we have the ability to “steal” other ideas from Warren Buffett, Seth Klarman, Michael Price, Mario Gabelli, Marty Whitman, etc.
Many times there are similarities between these successful value investors that can be used as guides when developing our own unique philosophy. One such similarity I would like to discuss is portfolio concentration.
The purpose of this article is to facilitate discussion about the optimal concentration of a portfolio. While each of us will settle on our own philosophy, discussion amongst one another will strengthen our knowledge about the topic. For example, I will lay out my argument as to why I think portfolio concentration makes sense. Ideally, there will be some of you that will disagree with some/all of my points. I want other readers to challenge ideas and/or discuss their own philosophy on the topic.
Another reader may offer an opinion that changes my own viewpoint and strengthens my overall philosophy. I think there are many different value approaches, if implemented and followed, that will lead to investment success. I think part of the battle is finding a philosophy that one has so much confidence and conviction in that he will remain disciplined to to stick to that philosophy even when it’s not working well in the short term. I hope this article can facilitate a discussion that improves our confidence in our own philosophy, even if we modify our own philosophy after discussing the topic.
Diversification is a word that is used frequently in investments, but in my opinion, is not fully understood. Few people understand that 8-10 businesses can offer over 80% of possible diversification and that there is minimal diversification benefit by owning more than 15 businesses. In my opinion, it doesn’t make sense to invest in any more than a maximum of 12-15 businesses. Rather, I would prefer to have a focused portfolio containing 8-15 businesses. I’m not implying diversification is not important, I do believe it is, but in my opinion, the benefit of diversifying has diminishing returns. In other words, at some point, the benefit of diversifying into additional investments does not exceed the costs. The following is what I believe are the advantages of a concentrated portfolio:
Easier to complete ongoing assessment of risk (avoiding losses)
In any portfolio, the only way to lose wealth is for the investments within the portfolio to permanently decline in value. This usually entails a reduction in future earnings power and/or a decline in asset value. Therefore, in order to avoid significant losses, an investor must complete an ongoing assessment of the earnings power and asset values of all the investments within the portfolio. Not every investment an investor makes will outperform the market. Every investor will make significant errors at some point. This is unavoidable. The key is to avoid large losses and to reduce the amount of losses we make over long periods of time. The importance of avoiding losses should not be understated.
Warren Buffett talks about his two rules of investing:
Rule No. 1 - Avoid losses.
Rule No. 2 - Don’t forget rule No. 1.
Warren Buffett and his partner Charlie Munger have also discussed the importance of inversion. That is, focus on the risks of an investment first and worry about the potential return second. Not only is this sound advice when analyzing new investments, but also for investments you currently own. Remember the only investments that will reduce wealth are the ones an investor actually owns.
Another example I will point to regarding the importance of avoiding losses is the following from “Margin of Safety,” written by Seth Klarman. Klarman writes, “Value investors, by contrast, have as a primary goal the preservation of capital.”
With avoiding losses being critical to long-term investment success, an investor should spend a great deal of time analyzing current holdings for changing/increasing risk. As the portfolio becomes more concentrated, the time required to analyze current holdings declines. One can assess risk more efficiently and thoroughly with 12 holdings compared to 50 holdings. Ideally, one needs to spend significant time completing an ongoing assessment of risk, but also needs to spend time finding and researching other ideas to improve the portfolio.
So there is a trade-off between researching businesses currently owned and researching potential businesses to own. If one spends too much time analyzing the risk of current holdings, future returns will likely suffer as one spends less time trying to find other compelling opportunities. If there is little diversification benefit after 12-15 businesses, then spending too much time analyzing current holdings of 45 businesses seems suboptimal. Rather, the time would be better spent analyzing potential opportunities.
Better risk-reward characteristics
The goal with any portfolio is to find the absolute best risk-reward opportunities. These opportunities should fit the criteria for selection, whatever those may be, best. On average, a more concentrated portfolio will have better risk-reward characteristics compared to a less concentrated portfolio. By limiting the number of businesses, the criteria for purchase becomes stricter. In other words, a portfolio comprised of the 10 best ideas will have better risk-reward characteristics, on average, than a portfolio with 50 ideas. It doesn’t make sense to allocate capital to the 20th best opportunity when the benefit of diversification at that point is virtually zero. An investor would be better served by allocating more capital to what they believe is their first or second best opportunity.
More time spent on finding great opportunities
Above I discuss the trade-off between time spent on analyzing current holdings and time spent on analyzing other opportunities. An investor needs to balance our analysis time between current holdings and potential opportunities. The more holdings one has, the less time one can spend on potential opportunities. Being too diversified will require significant time analyzing current holdings. Thus, the ability to analyze potential opportunities will be reduced. This would decrease the number of potential opportunities one could analyze, which would likely have a negative impact on future returns. To avoid this, I believe having a concentrated portfolio offers the optimal time balance between analyzing current holdings and analyzing potential opportunities.
By having a focused portfolio, one can thoroughly analyze current holdings, but still have sufficient time to analyze potential opportunities.
Each investment has greater impact on portfolio return
If an investor were to own 100 businesses in equal amounts, any one outstanding investment decision would have minimal impact on the overall portfolio return. However, if one were to own 10-15 businesses in equal amounts, any one outstanding investment would have a significant impact on the overall portfolio return.
Now, I realize one poor investment decision will also have a greater total impact to the portfolio return. However, this risk is minimized in two ways. First, keep in mind that having 10-12 businesses provides the majority of diversification benefit. Thus, any poor decision still has a good chance of being offset by another investment. Also, if done correctly, the strict criteria used to construct a concentrated portfolio reduces the amount of downside risk.
Higher conviction required- better and more thorough analysis
While the other advantages to having a focused portfolio are important, arguably the most important advantage is the greater amount of conviction needed to purchase an investment for the portfolio. That is, conviction must be higher for an investment that will represent 10% of the total portfolio compared to one that will only comprise 2% of the portfolio.
In my opinion, this deters an investor from making more speculative investments or investments that may not fit their selection criteria well. Often times, this will reduce irrational behavior onset by emotion. For example, it seems an investor would be more willing to take an uncalculated and large risk if the investment only represented a small portion of the portfolio compared to one that would represent 10% of the portfolio. The heightened intensity and scrutiny around each purchase will result in lowering the chance of making significant mistakes, whether the mistake is behavioral or not. By having a more concentrated portfolio, the conviction required to add an investment offers a benefit that far exceeds the minimal benefit of additional diversification.
Often times, there is less analysis and thought given to an investment that will only comprise 2% of the overall portfolio. This lack of analysis and scrutiny increases the chance of making significant mistakes. This is something all investors should avoid. Remember Rule No. 1 and Rule No. 2 from above. Thoroughly researching an investment idea can be extremely time consuming. An investor may have to research 10, 25 or 50 ideas before finding one attractive enough for the portfolio. Often times, this leads to an investment decision being less thought out and scrutinized than it should. However, if the investment will comprise 10% of the portfolio, an investor will be more likely to have a well thought-out thesis before adding it to the portfolio.
Lower transaction cost
Study after study continues to show investors that trade less frequently enjoy higher returns compared to investors that trade more frequently. Investors using a more concentrated portfolio, all else being equal, will have lower transaction cost.
Easier to assess quality of investment decision in hind sight
One of the important aspects of successful investing is continual improvement. No one is born a great investor. Rather, serious time, effort and education are required to master any craft. Investing knowledge is cumulative and an investor should continually become more knowledgeable. One of the best ways to learn more about investing is by practicing it and evaluating the results. However, many investors are lacking in this area. How many investors scrutinize their past investment decisions? What went right? What went wrong? Why did it go right/wrong? How could I improve upon my process?
By figuring out the answers to these questions, an investor becomes better. Maybe one will find his analysis of management is not thorough enough. Or maybe one will find his ability to analyze a certain industry is below average. Whatever it is, an investor becomes better by analyzing his past investment decisions. With time already sparse due the need to analyze the ongoing risk of current holdings and find new opportunities, an investor doesn’t have time to analyze 45 investment decisions that were likely not well thought out to begin with (and probably wouldn't learn much anyway). Rather, an investor would be better served to thoroughly scrutinize a handful of well researched investment decisions of a concentrated portfolio.
Easier to analyze an optimal portfolio construction
After a decision has been made to purchase an investment, one has to next determine the optimal decision regarding the portfolio. If I have cash available, should I put this to work while continuing to hold my other investments? Should I sell one or two current holdings to fund the new purchase? If so, which one or two? How much should I allocate to this idea? Does it offer better risk-reward characteristics than other holdings? Do I understand this business better than another holding that offers similar risk-reward characteristics? Does this business act as a hedge to a current holding? These are some of the questions that arise when determining the optimal portfolio. In order to answer these questions, an investor has to be able to compare current holdings versus the incumbent. In fact, an investor doesn’t even have to be adding a business to his portfolio to be asking these questions. The concept of portfolio optimization is constant and important. There are lots of moving parts. An investor has so much to consider when allocating dollars optimally. In my opinion, portfolio optimization becomes more manageable as the portfolio becomes more concentrated. An investor can more easily quantify the cost and benefits of adding a business, subtracting a business, or doing nothing with the portfolio. Optimization just seems too complicated with too many businesses within the portfolio.
Again, let me know your thoughts. Do you agree/disagree? Why? Are there other reasons you use a different level of concentration?
In addition, the fact that we are putting wealth at risk by using an uncertain strategy that must be committed to for a minimum of 7-10 years is mentally troublesome. If the strategy does not perform well for the first 10 years in comparison to other strategies, certainly one would have been better off using another strategy. This is the risk one has to be willing to take. Investing success is therefore, not only reliant on the validity of our philosophy, but also the conviction and discipline to stick to the philosophy over time.
Luckily an investor has the ability to learn from the best value investors of all time when building the foundation of our own investment philosophy. While each of us adhering to a value investing strategy has our own unique philosophy, we have the ability to “steal” other ideas from Warren Buffett, Seth Klarman, Michael Price, Mario Gabelli, Marty Whitman, etc.
Many times there are similarities between these successful value investors that can be used as guides when developing our own unique philosophy. One such similarity I would like to discuss is portfolio concentration.
The purpose of this article is to facilitate discussion about the optimal concentration of a portfolio. While each of us will settle on our own philosophy, discussion amongst one another will strengthen our knowledge about the topic. For example, I will lay out my argument as to why I think portfolio concentration makes sense. Ideally, there will be some of you that will disagree with some/all of my points. I want other readers to challenge ideas and/or discuss their own philosophy on the topic.
Another reader may offer an opinion that changes my own viewpoint and strengthens my overall philosophy. I think there are many different value approaches, if implemented and followed, that will lead to investment success. I think part of the battle is finding a philosophy that one has so much confidence and conviction in that he will remain disciplined to to stick to that philosophy even when it’s not working well in the short term. I hope this article can facilitate a discussion that improves our confidence in our own philosophy, even if we modify our own philosophy after discussing the topic.
Diversification is a word that is used frequently in investments, but in my opinion, is not fully understood. Few people understand that 8-10 businesses can offer over 80% of possible diversification and that there is minimal diversification benefit by owning more than 15 businesses. In my opinion, it doesn’t make sense to invest in any more than a maximum of 12-15 businesses. Rather, I would prefer to have a focused portfolio containing 8-15 businesses. I’m not implying diversification is not important, I do believe it is, but in my opinion, the benefit of diversifying has diminishing returns. In other words, at some point, the benefit of diversifying into additional investments does not exceed the costs. The following is what I believe are the advantages of a concentrated portfolio:
Easier to complete ongoing assessment of risk (avoiding losses)
In any portfolio, the only way to lose wealth is for the investments within the portfolio to permanently decline in value. This usually entails a reduction in future earnings power and/or a decline in asset value. Therefore, in order to avoid significant losses, an investor must complete an ongoing assessment of the earnings power and asset values of all the investments within the portfolio. Not every investment an investor makes will outperform the market. Every investor will make significant errors at some point. This is unavoidable. The key is to avoid large losses and to reduce the amount of losses we make over long periods of time. The importance of avoiding losses should not be understated.
Warren Buffett talks about his two rules of investing:
Rule No. 1 - Avoid losses.
Rule No. 2 - Don’t forget rule No. 1.
Warren Buffett and his partner Charlie Munger have also discussed the importance of inversion. That is, focus on the risks of an investment first and worry about the potential return second. Not only is this sound advice when analyzing new investments, but also for investments you currently own. Remember the only investments that will reduce wealth are the ones an investor actually owns.
Another example I will point to regarding the importance of avoiding losses is the following from “Margin of Safety,” written by Seth Klarman. Klarman writes, “Value investors, by contrast, have as a primary goal the preservation of capital.”
With avoiding losses being critical to long-term investment success, an investor should spend a great deal of time analyzing current holdings for changing/increasing risk. As the portfolio becomes more concentrated, the time required to analyze current holdings declines. One can assess risk more efficiently and thoroughly with 12 holdings compared to 50 holdings. Ideally, one needs to spend significant time completing an ongoing assessment of risk, but also needs to spend time finding and researching other ideas to improve the portfolio.
So there is a trade-off between researching businesses currently owned and researching potential businesses to own. If one spends too much time analyzing the risk of current holdings, future returns will likely suffer as one spends less time trying to find other compelling opportunities. If there is little diversification benefit after 12-15 businesses, then spending too much time analyzing current holdings of 45 businesses seems suboptimal. Rather, the time would be better spent analyzing potential opportunities.
Better risk-reward characteristics
The goal with any portfolio is to find the absolute best risk-reward opportunities. These opportunities should fit the criteria for selection, whatever those may be, best. On average, a more concentrated portfolio will have better risk-reward characteristics compared to a less concentrated portfolio. By limiting the number of businesses, the criteria for purchase becomes stricter. In other words, a portfolio comprised of the 10 best ideas will have better risk-reward characteristics, on average, than a portfolio with 50 ideas. It doesn’t make sense to allocate capital to the 20th best opportunity when the benefit of diversification at that point is virtually zero. An investor would be better served by allocating more capital to what they believe is their first or second best opportunity.
More time spent on finding great opportunities
Above I discuss the trade-off between time spent on analyzing current holdings and time spent on analyzing other opportunities. An investor needs to balance our analysis time between current holdings and potential opportunities. The more holdings one has, the less time one can spend on potential opportunities. Being too diversified will require significant time analyzing current holdings. Thus, the ability to analyze potential opportunities will be reduced. This would decrease the number of potential opportunities one could analyze, which would likely have a negative impact on future returns. To avoid this, I believe having a concentrated portfolio offers the optimal time balance between analyzing current holdings and analyzing potential opportunities.
By having a focused portfolio, one can thoroughly analyze current holdings, but still have sufficient time to analyze potential opportunities.
Each investment has greater impact on portfolio return
If an investor were to own 100 businesses in equal amounts, any one outstanding investment decision would have minimal impact on the overall portfolio return. However, if one were to own 10-15 businesses in equal amounts, any one outstanding investment would have a significant impact on the overall portfolio return.
Now, I realize one poor investment decision will also have a greater total impact to the portfolio return. However, this risk is minimized in two ways. First, keep in mind that having 10-12 businesses provides the majority of diversification benefit. Thus, any poor decision still has a good chance of being offset by another investment. Also, if done correctly, the strict criteria used to construct a concentrated portfolio reduces the amount of downside risk.
Higher conviction required- better and more thorough analysis
While the other advantages to having a focused portfolio are important, arguably the most important advantage is the greater amount of conviction needed to purchase an investment for the portfolio. That is, conviction must be higher for an investment that will represent 10% of the total portfolio compared to one that will only comprise 2% of the portfolio.
In my opinion, this deters an investor from making more speculative investments or investments that may not fit their selection criteria well. Often times, this will reduce irrational behavior onset by emotion. For example, it seems an investor would be more willing to take an uncalculated and large risk if the investment only represented a small portion of the portfolio compared to one that would represent 10% of the portfolio. The heightened intensity and scrutiny around each purchase will result in lowering the chance of making significant mistakes, whether the mistake is behavioral or not. By having a more concentrated portfolio, the conviction required to add an investment offers a benefit that far exceeds the minimal benefit of additional diversification.
Often times, there is less analysis and thought given to an investment that will only comprise 2% of the overall portfolio. This lack of analysis and scrutiny increases the chance of making significant mistakes. This is something all investors should avoid. Remember Rule No. 1 and Rule No. 2 from above. Thoroughly researching an investment idea can be extremely time consuming. An investor may have to research 10, 25 or 50 ideas before finding one attractive enough for the portfolio. Often times, this leads to an investment decision being less thought out and scrutinized than it should. However, if the investment will comprise 10% of the portfolio, an investor will be more likely to have a well thought-out thesis before adding it to the portfolio.
Lower transaction cost
Study after study continues to show investors that trade less frequently enjoy higher returns compared to investors that trade more frequently. Investors using a more concentrated portfolio, all else being equal, will have lower transaction cost.
Easier to assess quality of investment decision in hind sight
One of the important aspects of successful investing is continual improvement. No one is born a great investor. Rather, serious time, effort and education are required to master any craft. Investing knowledge is cumulative and an investor should continually become more knowledgeable. One of the best ways to learn more about investing is by practicing it and evaluating the results. However, many investors are lacking in this area. How many investors scrutinize their past investment decisions? What went right? What went wrong? Why did it go right/wrong? How could I improve upon my process?
By figuring out the answers to these questions, an investor becomes better. Maybe one will find his analysis of management is not thorough enough. Or maybe one will find his ability to analyze a certain industry is below average. Whatever it is, an investor becomes better by analyzing his past investment decisions. With time already sparse due the need to analyze the ongoing risk of current holdings and find new opportunities, an investor doesn’t have time to analyze 45 investment decisions that were likely not well thought out to begin with (and probably wouldn't learn much anyway). Rather, an investor would be better served to thoroughly scrutinize a handful of well researched investment decisions of a concentrated portfolio.
Easier to analyze an optimal portfolio construction
After a decision has been made to purchase an investment, one has to next determine the optimal decision regarding the portfolio. If I have cash available, should I put this to work while continuing to hold my other investments? Should I sell one or two current holdings to fund the new purchase? If so, which one or two? How much should I allocate to this idea? Does it offer better risk-reward characteristics than other holdings? Do I understand this business better than another holding that offers similar risk-reward characteristics? Does this business act as a hedge to a current holding? These are some of the questions that arise when determining the optimal portfolio. In order to answer these questions, an investor has to be able to compare current holdings versus the incumbent. In fact, an investor doesn’t even have to be adding a business to his portfolio to be asking these questions. The concept of portfolio optimization is constant and important. There are lots of moving parts. An investor has so much to consider when allocating dollars optimally. In my opinion, portfolio optimization becomes more manageable as the portfolio becomes more concentrated. An investor can more easily quantify the cost and benefits of adding a business, subtracting a business, or doing nothing with the portfolio. Optimization just seems too complicated with too many businesses within the portfolio.
Again, let me know your thoughts. Do you agree/disagree? Why? Are there other reasons you use a different level of concentration?
