One of the biggest differences between my own investing and what readers really get from what I write about is the importance of concentration.
People who read my articles put less in the stocks they like than I do. In fact, I haven’t met someone who bets bigger on the ideas they like most than I do. This has huge implications for my own investment returns versus the investment returns someone reading and even copying my stock “picks” gets. For example, I invested in Weight Watchers (WTW, Financial). I bought the stock probably around $37 per share and sold it probably around $19 per share. I think it touched $4 per share somewhere in there. For the average people reading my blog, my GuruFocus articles, etc., and acting on the ideas I had – this would be a big loser as a stock, but it wouldn’t be a big loser for their net worth. I put 25% of my net worth into Weight Watchers. I lost more than 12% of everything I owned on this one stock when I finally sold it. The “paper” loss was even bigger at one point. I probably lost something like 23% of everything I owned on paper.
I don’t have a problem with this. A lot of people do. It’s important to understand if you are the kind of person who does have a problem with losing anywhere from 12% to 23% of your net worth on a single stock-picking mistake.
I should say here that we are not talking about what is right and what is wrong mathematically. I know I’m right mathematically and other people are wrong on this one. There’s just no way that putting 2% of your portfolio into each stock instead of 20% into each stock can possibly make sense. I use equal-sized positions of about 20%. I’ll explain in a moment why I do it exactly that way, but  the exact sizing I choose is not really important. What matters is that I never do 2% positions or 5% positions, and I have done 20% and 50% positions. I’ve done 50% positions rarely and I’ve never suggested anyone but me go over 50%. Still, what we’re talking about is an “order of magnitude” type difference. That’s what I want to focus on. Should you ever make 2% bets? Should you ever make 20% bets? My opinion is that 2% bets don’t make any sense and 20% bets do make sense – and that there are pretty much no circumstances under which it would make sense to bet just 2% of your portfolio on something.
Now, I will admit that buying 2% of a specific security might make sense if you were using a basket of stocks as a single decision. For example, when I was buying Japanese net-nets, I went looking for five to 10 net-nets trading in Japan in which I could put about 5% of my portfolio individually and thus 25% to 50% of my portfolio as a group operation, but it’s very important to note that this was always conceived of as a 25% to 50% bet on a basket of Japanese stocks that met two criteria: 1) They had 10 straight years of positive profits, and 2) they had a negative enterprise value.
I didn’t understand the businesses, the management teams or the industries they were in. I diversified that risk by looking for 5 to 10 such stocks in which I could put 5% to 10% of my portfolio. I didn’t feel I was sacrificing selectivity for diversification because I didn’t know how to tell one Japanese net-net from another. They all shared the risk of being denominated in yen instead of dollars, and then they had specific risks related to capital allocation, industry economics, competitive positions, etc. Since I don’t read Japanese and don’t know Japanese business culture well enough to tell one Japanese company from another in these respects – it made sense to simply buy them indiscriminately if they met basic quantitative criteria.
The two criteria I decided on were a required combo of negative enterprise value (that is, the company had to be selling for less than the cash it would have after settling all its liabilities) and 10 straight years of profits. I knew that any company anywhere in the world that met both those criteria and wasn’t a fraud would eventually trade for more than the price for which it was selling. Diversifying across five to 10 “sure” purely quantitative bets made sense to me.
Some people still consider this a moment where I diversified more than usual by taking 10% positions or even 5% positions. I don’t see it that way. I didn’t attempt to pick one of these Japanese stocks over another so I wasn’t diversifying in the sense of making more stock picks than a concentrated investor. Yes, there were more stocks in my portfolio, but I wasn’t “picking” more stocks. I picked the strategy of buying negative enterprise value Japanese stocks with at least 10 straight years of profits. Once I picked that strategy, I basically just bought everything I could identify that fit the strategy. I would have been willing to buy four such Japanese stocks or 40 such stocks. Statistically, there’s really no point in buying 400 such stocks even if they do exist. A sample of 40 isn’t going to be much different than a full population of 400 – if such a population existed. It didn’t. I went through the Japanese stock exchanges manually – so I might have missed a few negative enterprise value stocks with 10 straight years of profits, but I knew there were closer to 10 such stocks than 100 or 1,000.
Let’s stick with this theme of big differences in size rather than small differences in size. What is the ideal portfolio size? If you’re right, it’s obviously one stock. In the long run, a group of 100 know-something investors will compound capital the fastest by each betting on only one stock at a time. Some will go broke. Not as many as you’d think (because few will fail right out of the gates, and early successes can give you room for miscalculations later). But, yes, some will fail. Investors obviously don’t want to end up with zero. You only live once. You only save for retirement once. You can’t comfort yourself by saying that a group of 20 one-stock portfolios will beat a group of 20 three-stock portfolios. You might be that one out of 20 that goes to zero. What is the right number of stocks in a portfolio?
I use a five-stock portfolio. Warren Buffett has said that’s roughly what he and Charlie Munger (Trades, Portfolio) liked to use when they were running their partnerships. What he seems to have meant by this is that 80% to 90% of his portfolio was in five or fewer ideas. Since I use a five-stock portfolio, let’s think in terms of powers of five. We already considered a one-stock portfolio. That’s five to the zeroth power. What’s five to the first power? That’s five. And what’s five to the second power? That’s 25. And five to the third power is 125. We have enough to work with using just those three “jumps” up in size.
Which works best: a one-stock portfolio, a five-stock portfolio, a 25-stock portfolio or a 125-stock portfolio? We can safely disregard the 125 (five to the third power) portfolio. It makes no sense. I’ve never seen an academic study suggest that picking more than 30 stocks (if you’re just adding to the stocks you pick, not the ways you pick them) adds any material amount of “safety” in the sense of lowering either stock-specific risk or market risk. Even if we’re talking short-term volatility in price, 125 stocks aren’t going to look different as a portfolio than 25 stocks. They are going to require more work, more trades, etc. We can disregard a 125-stock portfolio as nonsensical when compared to a 25-stock portfolio.
In terms of snapshot-type efficiency – a single bet when considered as the only bet you will ever make – the one-stock portfolio is undeniably the best. It has been my experience that the one bet investors would make if only allowed to make one bet is usually among the best bets they could make. It is almost never among the worst bets. In fact, the thing I notice most when encouraging investors to shrink the number of positions they have is that they eliminate high risk/high reward stocks. A lot of investors keep riskier stocks in a 20-stock portfolio than they ever would in a two-stock portfolio. It’s worth thinking about that.
Does that actually make sense? Investors may tell themselves that it makes sense to take bigger risks with smaller positions – it’s OK to take speculative risks with a 20-stock portfolio. Is it really? The results good investors get on concentrated portfolios is pretty good. And it’s pretty good over fairly long periods of time. It also tends to be concentrated in “high probability bets” as Buffett would call them. That doesn’t have to be the case. For example, Buffett bought something like 30 Korean stocks with very low price-earnings (P/E) ratios after the Asian Financial Crisis in the 1990s. I bought a basket of Japanese net-nets. I consider each of those Japanese net-nets to have been high probability bets in the sense that being simultaneously priced below your net cash level and also being consistently profitable almost always leads to a good outcome for the stock – and yet I didn’t make a concentrated bet on any one of these stocks. I didn’t have to. I could make a 25% to 50% bet on them as a group. That was my concentrated bet. It just was concentrated in one strategy rather than one stock. I didn’t see the benefits of concentration in such a situation. I diversified across a basket of stocks with similar characteristics.
What is the problem with a one-stock portfolio? I see two problems. The problem you are probably imagining is that the stock in which you invest will go to zero, and your compounding will be at an end. Honestly, that is a huge theoretical problem – but I don’t consider it the main practical problem. If you are an above-average investor who is willing to put 100% of your net worth into a single stock that goes to zero – some really, really weird external event has to happen to bring that stock to zero. I have made some very bad stock decisions with 5% and 25% of my portfolio. I wouldn’t buy any of those stocks with 100% of my portfolio. There are so few stocks in my life in which I would ever put 100% that this approach would leave me often in nothing but cash rather than betting on a stock with any meaningful risk of going to zero. What’s the big problem then?
It’s liquidity. To take advantage of times when there is “blood in the streets” or something like that you need cash. With a one-stock portfolio you would be 100% invested. If the whole market dropped 40% in a single year, you’d have to stick with the stock you already owned or sell it at a big discount to intrinsic value just to buy something else. In fact, that’s the really big problem. Selling the stock you believe in most in the world – which is all you’d own in a one-stock portfolio – is really, really hard to do. A one-stock portfolio suffers from two defects. One, it isn’t as reliable as it could be. There is some chance that you could go completely broke pursuing a one-stock strategy. This is the scary risk. The less scary sounding risk – but the one that almost certainly will affect your actual compounding over time –Â is the inflexibility of this strategy. You would have to sell your favorite stock in the world to switch into something new. A one-stock portfolio could quickly become buy and hold to a degree that might be a lot less than optimal. A one-stock portfolio is too unreliable and too inflexible.
Let’s pause to consider “reliability.” Looking at a portfolio – or a business – as it moves through time, I like to think in terms of reliability and efficiency. The easier concept to quantify and prove the correct answer to is usually “efficiency.” The most efficient positioning for your portfolio at any single point in time is to have the biggest possible bet made where the odds are most in your favor. You always maximize efficiency at a 100% bet on your single best idea. However, this kind of bet is “unreliable” in the sense that a series of 100% bets will always eventually end up with you going broke. I mean this in a theoretical sense. It could take a thousand years for a model portfolio of one-stock bets repeated over and over again to go broke, but one day it will go broke. We trade efficiency for reliability. How much of a trade do we need to make?
The reason I choose five equally sized positions of 20% each may surprise you. It’s so I can always buy something I like. That’s it. Bets much less than 20% don't make much sense. They’re too small, but I also really like being able to act quickly when I see the odds in my favor. It’s possible that a three-stock portfolio would be ideal. Munger has suggested three stocks are the minimum amount with which he’d be comfortable. I agree that the right number of stocks in a portfolio is almost certainly more than one, and I doubt it’s bigger than five. Three sounds right, but three may be right in a “hold” only portfolio and yet wrong in a “buy” and hold portfolio.
Why?
The problem with a three-stock portfolio is that you’d always either need to sell one of your three favorite ideas or hold 33% of your portfolio in cash awaiting a new idea. There also start to be real liquidity concerns that worry me with a three-stock portfolio. Again, this has to do with the difference between the ideal “buy and hold” portfolio size versus the ideal “hold” only portfolio. I tend to believe three stocks might be the ideal hold forever portfolio, but I feel it’s definitely wrong for me in terms of initiating new buys.
I like illiquid stocks. They often offer some of the best returns. As a smaller investor, the ability to bet a big percentage of your net worth on illiquid stocks is a huge advantage, but let’s imagine you find two truly illiquid stocks – things like George Risk (RSKIA, Financial) that may only trade an average of $3,000 or so a day. In a three-stock portfolio, two illiquid micro-caps would fill up 67% of your portfolio. If you ever needed to take a fair chunk of money out of your portfolio because of a family emergency, to pay taxes or simply to reposition your investments – you’d only have immediate access to 33% of your portfolio. That might be too little to make you comfortable. For that reason, an investor who holds only three stocks might feel he has to make two of those stocks “liquid” stocks. That’s a disadvantage.
Meanwhile, an investor with a five-stock portfolio, would be able to own two illiquid stocks and still have 60% of his portfolio in liquid assets. No one should need immediate access to more than half of their “savings.” If you need access to more than 60% of the money you have saved, you shouldn’t be invested in common stocks at all. You should be in cash or maybe government bonds that will mature reasonably soon. That’s really all you can afford to risk being in if you might have to spend most of the portfolio sometime soon.
The other advantage of a five-stock portfolio is that I don’t think a 20% cash position – on average – is excessive. I do think a 33% cash position – on average – may be excessive. I’m not sure I’d feel comfortable normally leaving one “slot” free in a three-stock portfolio while I would – and do – feel totally comfortable leaving one “slot” free in a five-stock portfolio. That’s my default. I want to be 100% invested, but I understand that I’ll probably average being only 80% invested if we look at the portfolio over time. For example, I’ve been 30% to 50% in cash just because I was bought out of some stock in a going private transaction and didn’t have another great idea to pounce on right away.
A five-stock portfolio can more flexibly accommodate up to two illiquid stocks (40% of the portfolio) and some idle cash (up to 20% of the portfolio) that can immediately be put to use without having to sell anything. Not having any cash means not being able to use “timing” of purchases at all.
Why not vary the size of positons? Why not take a 50% position, a 25% position, a 12% position, a 6% position and a 3% position depending on how much I like each?
Again, as a “hold” portfolio this might make sense. It’s true that I – and other investors – sometimes have pretty strong preferences between our first favorite and fifth favorite ideas. It would make sense to bet up to 50% in some situations. That’s not a very flexible strategy. Forming new 50% positions and new 25% positions would be difficult, and those two positions are 75% of your portfolio in that situation. You’d be creating some problems for yourself in terms of timing and liquidity. You might miss out on some opportunities.
OK. I personally use a five-stock portfolio with equal position sizes of 20% per stock. Does that mean I think that’s the best allocation for something like a mutual fund, a pension fund or an endowment?
No. Actually, I think a 25-stock portfolio is best, but this takes some explaining. Based on everything I’ve read about diversification in theory and everything I’ve seen about diversification in practice, I can see a big divide between what makes a five-stock portfolio best and what makes a 25-stock portfolio best. The portfolio that is likeliest to give you high returns with low volatility would be in the 25-stock size range, but it has a huge downside. A 25-stock portfolio is not something you can implement with highly skilled stock pickers. Stock pickers just don’t have the ability to “express” their skill at high levels when spread over that many stocks. It may be true that 25 ideas are the best combination for an investor to hold, but it is definitely not true that 25 ideas are the best number for an analyst. There is a severe dropoff in idea quality between five ideas and 25 ideas. There is some benefit to diversifying between five and 25 stocks. However, there really isn’t a diversification benefit beyond 25 stocks.
The ideal way to run a fund would be to find five managers who could each independently select five stocks and thereby fill a fund with 25 stocks that are all “top 5” ideas for the analysts who chose them. Can you implement this strategy yourself?
Sure. You could form an investing club with people you meet online at places like GuruFocus. But would you really trust other people’s ideas with 80% of your assets?
I don’t know about that.
Most individual investors face the trade-off of going beyond having five stocks in their portfolios and thereby reducing selectivity or surrendering some of the autonomy they enjoy in their stock picking. Personally, if I liked the other guy, I’d rather fill my portfolio with his five best ideas than my 21st to 25th best ideas. I’m weird that way, but if your five best ideas are worse than my 21st through 25th ideas, you’re not a good stock picker. Flip that, and you’ll see that if you can find someone who is a good stock picker – you should put more trust in his top five ideas than in your 21st through 25th ideas.
I have no such person to trust with my money, and I don’t mind volatility, but if I did mind volatility, I’d do what I just described above. In the long run, that 25-stock portfolio would compound at a lower rate than a five-stock portfolio. However, for people who care a lot about not having volatility much in excess of an index fund, 25 stocks are a better choice than 5 stocks. You’re not going to reduce volatility by going beyond 25 stocks. There are ways to reduce volatility below that of an index fund, but simply picking more and more stocks is never going to do it. Twenty-five stocks will basically get you index fund levels of volatility, and you can’t get less volatility than an index fund through further diversification.
If you want to reduce volatility, there’s no point owning more than 25 stocks at once. If, like me, you don’t care about volatility – but you do care about reliability (basically business risk) and flexibility (basically the ability to buy illiquid stocks and “time” position entry) – you should own far fewer than 25 stocks. I usually own five at a time, and there’s a lot of anecdotal support for that in the record of some good long-term investors like Buffett and Munger. They claim that most of their early record – and remember, their early record was their best record – was achieved while putting something like 80% or 90% of their portfolios into something like five stocks at a time.
The topic I haven’t even considered here is the length of the holding. This is where the concentrated investor can really “concentrate his concentrating.”
A huge mistake investors make when considering portfolio construction is using a snapshot approach (discrete time) versus a historical approach (continuous time). The reason you’re investing is to compound your wealth over time. It doesn’t just matter what you buy. Buying right is a necessary but insufficient driver of your compounding. An investor’s return comes not from buying right but from holding right. For this reason, I’ve proposed a set of three rules from which most stock pickers can benefit.
Rule No. 1: Never put less than 20% of your net worth into a stock.
Rule No. 2: Never own a stock for less than five years.
Rule No. 3: If you’re uncomfortable with Rule No. 1 or Rule No. 2, you’re wrong about the stock.
In other words, I can understand your circumstances sometimes dictating that you put less than 20% into a stock or own it for less than five years. That’s perfectly reasonable, but think hard about whether something you’d be unwilling to put 20% of your portfolio into or agree to “lock up” for five full years is safe enough and good enough to put any of your portfolio into. You’ll have other ideas. Why waste dry powder on something you’re uncomfortable betting on in a big way for a long time?
There can be good reasons – like not having idle cash right now – for putting less than 20% of your portfolio into something, but that’s not a reason inherent to the stock idea. It’s a portfolio consideration. Likewise, there can be reasons – like finding an even better stock – for selling something you own before you’ve held for five years, but, again, that’s not something inherent to the stock idea. If a stock idea is inherently attractive as a three-year investment but not as a six-year investment – that’s clearly not a world-class idea you have there. Likewise, if a stock idea is attractive when it’s 10% of your portfolio but not attractive when it’s 20% of your portfolio, something is seriously wrong with that idea.
Not everything has to be a good idea forever. For example, I like Howden Joinery (LSE:HWDN, Financial) as a five-year investment. I do realize that it will run out of places to put additional depots inside its home market of the U.K. in about five years. It stops being a predictable growth stock in about five years. It might get growth from other places – but that’s not predictable, it’s speculative, and it might start buying back a lot of stock, really upping the dividend, etc., once it fully saturates the U.K. For now, I’d only be comfortable owning it for five years as a commitment I can agree to now. If things go well, a five-year investment could become a 10-year investment, but that kind of situation is enough. If I’m willing to put 20% of my portfolio into Howden (and I am) and I’m willing to hold it until 2022 (and I am), then Howden qualifies as a “good idea” even though I’m not sure I would buy and hold it forever.
Howden fits my three rules, and I think it would fit those three rules even if I happened to only have 10% of my portfolio free at the moment I found it and therefore only got a chance to put 10% into the stock before the price moved or something. In that case, it would be a 10% position, but I wouldn’t feel I had compromised my selectivity by picking it. It would just have been some inadvertent diversification.
The important thing is to always focus on holding the fewest possible stocks for the longest possible time. That’s how you compound wealth.
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