Someone who reads my blog emailed me this question:
“What is the maximum concentration you would employ in any single stock, why, and under what conditions, qualitative and quantitative, would you do so?”
This is a tough question because I’m not sure I want to recommend what I would do as the right practice for others to follow. I am more comfortable holding a smaller number of stocks – and putting more in each stock – than most people are. My ideal is to buy one stock per year and hold each stock for five years. That means the portfolio for which I am always aiming would have five positions each sized at 20% of my whole account.
I’m not sure if that is right for other people. In fact, it’s wrong for some people. I get plenty of emails from people talking to me about a stock they own that has declined a lot. For example, I own shares of Weight Watchers (WTW, Financial). I bought them years ago at a much higher price than the one for which the stock now trades. People have contacted me who invested in that stock. They’ve talked to me when it was down maybe 20% from where they bought it and when it was down more like 90% from where they bought it.
Let’s say – for the purposes of this discussion – that the average people who emailed me about Weight Watchers put 20% of their accounts into the stock. And then the stock lost 50% of its value. It lost a lot more than that at one point. Obviously, a lot of people put less than 20% of their portfolios into Weight Watchers. But it’s not a bad estimate for the purposes of this discussion to assume the people who are emailing me put 20% of their accounts into a stock and then that stock lost – perhaps permanently – 50% of the original purchase price. Let’s go with that assumption. That’s a 10% loss in the overall portfolio. This is painful. But let’s put this in perspective.
The Shiller price-earnings (P/E) ratio – a measure of the stock market’s price to normalized earnings – is now 27. A normal Shiller P/E is about 16. One should expect a decline – in fact, a permanent decline – in the portfolio of 11 points on the Shiller P/E. If you own an index fund right now you should be prepared to lose about 40% of the value of your account. That’s not a one-time loss, either. It’s a permanent adjustment. On average, the Shiller P/E should be 16 rather than 27. We are talking here about 27 minus 16 equals 11. And 11 divided by 27 equals 41%. Let’s call it a 40% decline. Even if your portfolio is now 50% cash and 50% the Standard & Poor's 500 – you should still expect a loss of 20% of your account if the market adjusts to a normal Shiller P/E. That’s double the loss I talked about in Weight Watchers.
Again, assume you put 20% of your account into Weight Watchers and lost 50% of the value of the stock. You have a 10% loss. What if it’s a total loss? Weight Watchers has a ton of debt. Plenty of people think it will start losing subscribers again. It’s heavily shorted. Let’s say it does go to zero. If you put 20% of your account into a stock and it loses 100% of its value, you lose 20% of your account. The stock market is priced to drop about 40% to get to a normal Shiller P/E. To duplicate your complete loss in a stock like Weight Watchers you’d need to have 50% of your account in cash and 50% in an index fund.
Most people have a lot more than 50% of their account in stocks generally. Stocks generally are priced to lose 40% of their value. Is it really that big a risk to put 20% of your account into a stock? Yes. It’s risky. Any time you buy stocks when the market is above a Shiller P/E of 16 you are taking a risk. The average investors don’t believe they are taking much of a risk when they buy an S&P 500 index fund today. However, they would think it was a huge risk to put 20% of their account into two different stocks – each of which could, in some scenario, conceivably decline to zero.
The downside risk is the same in these two situations. Putting 20% of your portfolio into Stock A which has some chance of going to zero and putting 20% of your portfolio into Stock B which has some chance of going to zero can’t possibly be riskier than putting 100% of your money into an index that has a good chance of declining 40%. For me, the long-term base case for the S&P 500 is a decline of 40%. Now, you aren’t going to invest in two different stocks where you think the base case is a total loss. You’re going to be taking less risk.
Most people don’t see it that way, and they certainly don’t feel it that way. The loss on a single stock they picked feels different than a big decline – like the 2008 decline – in the S&P 500 in which all investors share. There are several reasons for this. You are looking at the magnitude of the loss in terms of the amount you allocated rather than the amount of your total portfolio. A 40% decline in all your stocks somehow feels different than a 100% loss in 40% of your stocks. Both losses are – of course – the same in terms of where they leave your portfolio after the loss.
The other way the loss feels different is that a stock you pick on your own and loses money is a loss where you were operating “outside the herd.” It’s an egregious loss. Meanwhile, a loss because you own the same stocks as everyone else and those stocks decline is an “inside the herd” decline. It’s the same sort of loss everyone else is feeling. There is no culpability.
That is how a lot of people feel. I don’t feel that way. I feel you are equally culpable for buying the S&P 500 when it’s clearly overvalued as for making a mistake in judging the moat around some specific stock you pick. What we are concerned about here is the financial loss. We shouldn’t be worried about feelings of guilt, shame, etc. What if others were right and you were wrong? Being wrong when anyone else is wrong isn’t any less financially harmful than being wrong when everyone else is right.
You asked about diversification and concentration. My answer included a discussion of the overall market valuation. That might seem off topic. Talking about something like the risk people are taking buying into an elevated Shiller P/E right now explains why it’s OK to concentrate. We take a lot of different risks when we invest. For whatever reason, we tend to think of some risks as normal, appropriate, etc., for an investor to take.
At the same time, we condemn other risks as arrogant. People will say it is arrogance to bet 20% of your portfolio on one stock – especially a contrarian stock others are shorting. They will say it’s reasonable and understandable – though wrong in hindsight – to buy into clearly overvalued assets like U.S. stocks which are now clearly overvalued. There’s no difference. Joining in with the crowd by ignoring an obvious risk is not smarter, more moral, etc., than making a large bet that others think is risky.
Some of this has to do with the power of story and the power of morality. After the fact, it’s easier to explain losses by putting them in the form of some sort of story with a hero, a villain, moral defects, etc. This has no place in investing. Losing a lot of money buying the S&P 500 today or buying into oil stocks a few years ago or housing stocks a decade ago, etc., is no different than putting something like 20% of your portfolio into Weight Watchers and losing half or all of it. We are talking about taking the same sort of risks in terms of size. And yet people will treat bubbles in oil, housing and stocks as these things you can’t foresee and in which you must not blame yourself for getting caught up.
I wouldn’t spend much time blaming myself for either kind of mistake. They’re the same. You deserve the same amount of blame, praise, etc., regardless of how many people joined you in a good decision or how many people were smarter than you in avoiding a bad decision. To me, it’s just a matter of the math.
There are some advantages in diversification at the level of five and 10 stocks. If you diversify by country, stock size and industry – it can make sense to diversify as widely as 10 stocks. It’s fine for people to own 20 stocks if they really want to. If it makes you feel better, do it. I’m not sure there’s any real advantage in owning 20 stocks instead of 10 stocks. You haven’t reduced risk much. Not the kind of risk there is in all your stocks.
Owning stocks outside your own home currency and not hedging them can add diversification. Adding stocks that benefit from higher interest rates – since all the other stocks in your portfolio suffer from having lower P/E ratios when rates rise – helps you diversify. And owning completely illiquid stocks – like George Risk (RSKIA, Financial) – helps you diversify.
My two biggest holdings are George Risk and Frost (CFR, Financial). Frost benefits from higher interest rates. George Risk is illiquid to the point where the beta on the stock – a measure of how it moves in relation to the S&P 500 – ranges from quite low to negative. A negative beta on a stock is rare. It means the stock’s movements are not positively correlated with the overall market. If you look at your portfolio, you’ll notice that a lot of your stocks have positive betas around 1. That indicates movements similar to the overall market. Likewise, you’ll notice that few of the stocks in your portfolio benefit from higher interest rates. Stocks like Progressive (PGR, Financial), Bank of Hawaii (BOH, Financial) and Frost do. Most stocks don’t. Most investors are – without thinking about it – heavily exposed to the risk of rising interest rates in almost each and every stock in their portfolios.
The risk is a contracting P/E multiple. The biggest risks that most investors face are that the stocks in their portfolios are generally: 1) overpriced and 2) likely to decline as interest rates rise. Rising interest rates and declining investor sentiment (market momentum) can harm all their stocks equally. You can own five stocks, 10 stocks, 20 stocks, 40 stocks, 80 stocks or 160 stocks. Those two risks will still be there.
They are easiest to avoid the smaller your portfolio is. That’s my reason for putting a lot in one stock. I’m not someone who thinks about the Kelly Formula or betting big on my favorite ideas. I put a lot into one stock because I want to own very few stocks. It’s not that I want to put more money into my favorite idea than my seventh-favorite idea. It’s that I want to eliminate my seventh-favorite idea entirely. The more stocks I pick, the more risks I never even thought about will creep into my portfolio.
That’s why I concentrate my investments. What’s the most I’d ever put in one stock? Normally, I only put 20% to 25% in one stock. I don’t sell the stock as it rises. If one stock rises a lot while the rest of my portfolio falls – it could end up accounting for a large percentage of the account. I almost never put more than 20% to 25% of my account into a stock when I buy it.
The most I ever put into one stock was Bancinsurance. This was a very illiquid, micro-cap stock. I had been following it for years but had never bought the stock. It went through some temporary trouble. The company was a niche insurer. It wrote some insurance outside that niche. I think it managed to destroy about 25% of its equity doing so. The company’s auditors resigned. The SEC opened an investigation into the company. And A.M. Best lowered its financial strength rating for the company.
The biggest concern for me was the third one. An insurer like this needs a decent A.M. Best rating. The stock dropped to probably $4.50 per share at some point. Eventually, the SEC closed its investigation without taking any action. The controlling shareholder (and CEO) offered to buy out the minority shareholders at $6 per share. I think the company had like $8.50 per share in book value at that point. I had started – just barely – to nibble at the stock before the offer was made. I wasn’t sure whether the deal would go through at $6 per share, there’d be a higher offer, or the CEO would just withdraw the offer. I was fine with any of those three scenarios. I thought it was maybe 50/50 (my totally unscientific gut judgment) that the deal would simply be done at $6 per share. But I bought as much stock as I could up to the latest offer the CEO had made.
During the process, the offer was raised twice. The stock would have dropped if the offer had been withdrawn, but then I’d own a lot of shares – more than I otherwise could’ve gotten in such an illiquid company – at a fraction of book value. If the deal was done at $6 per share, I would have made a small – possibly very small – arbitrage profit. I think I ended up with an average cost about 3% less than the original offer. If the deal was done at the original offer, I would have made 3% raw return and maybe something in the 6% to 12% annualized range depending on how quickly the deal was closed. As it turned out, I was able to put close to 50% – but a lot less than I wanted – of my account into the stock. Book value kept rising while negotiations were ongoing.
The final deal was done about 40% higher than my cost in the stock. It took less than a year. It was a good deal in the sense that I put about 50% of my portfolio into a stock that gained about 40% in less than a year. That added about 20 percentage points of overall portfolio performance to one year’s result. A good outcome. Better than I ever expected.
That’s the circumstance under which I’d make the biggest bet. I was willing to put virtually unlimited amounts of my portfolio into Bancinsurance. For a Buffett example, look at American Express (AXP, Financial). He bought that stock during the salad oil scandal. I think he maxed out at 40% of the partnership’s portfolio. Originally, Buffett had a self-imposed limit of putting no more than 25% of the partnership’s money in one stock. For the average investor, 20% is a good limit. I’ve met few people who are as willing to concentrate as Buffett was in the 1960s or as I am now. My newsletter co-writer, Quan, feels the same way I do about concentration. Even though we were doing one idea per month for the newsletter’s subscribers – the two of us were each only looking to find one good idea per year in which to invest.
That’s always my own goal. I look for one good idea per year, and I hope it’s an idea I’ll hold for five years. So I target five stocks each sized at 20%.
Disclosure: Long Weight Watchers, Frost and George Risk.
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