But while these investors have been able to make billions of dollars using such an approach, it is not suitable for all investors. Indeed, everyone has heard of Buffett and Munger, but how many other thousands of investors are there out there who tried to use such an approach but failed?
The benefits of diversification
Diversification helps prevent you from flaming out and making an oversized bet on a company that may not be what it seems. For most investors, this is the only route. Unfortunately, the downside of this approach is standard returns. You will never outperform by running a highly diversified portfolio and if you track the market – the ultimate form of diversification – you will only ever achieve market average returns.
That is not to say that you should never have some concentration in a portfolio. If you want to own a highly concentrated portfolio, it’s vital you do your research. Knowing the ins and outs of every company as well as industry fundamentals, management incentives, past management performance and even such things as relationships with suppliers all should be considered if you’re planning to invest in a small portfolio of five companies or fewer.
The best of both
Most investors just don’t have the time to do this sort of in-depth research, and trying to invest in a concentrated manner without conducting rigorous due diligence will only end in tears.
However, another way to potentially outperform is by using a core and satellite-style portfolio. This approach is favored by renowned value investor Seth Klarman (Trades, Portfolio) who contributes a significant amount of capital to his top three or four ideas while diversifying the rest of the portfolio. For example, according to Baupost’s fourth-quarter 13F SEC filing, the hedge fund allocated just under 50% of its assets to the top five positions with nearly 40 other positions filling out the rest of the equity portfolio. By using this approach, investors can benefit from both the possible upside of concentration and downside protection of diversification.
Replicating the strategy
Personally, I employ a similar strategy in my stock portfolio. Around 30% of assets are devoted to four core positions, which are not particularly undervalued or high growth, but they all have a record of producing steady returns for investors and should grow steadily over the next two or three decades.
With this strong core in place, I am comfortable taking more risk in the rest of the portfolio, safe in the knowledge that even if my equity analysis isn’t up to scratch for small caps, the large core positions will continue to churn out dividends and steady growth year after year.
This mix of diversification and concentration is the perfect blend from most nonprofessional investors. With the core positions doing all of the heavy lifting the chance of outperformance is improved as there will always be a steady base of returns for the portfolio to grow from.
Last year, my personal portfolio yielded 1.5% from the core positions alone – that’s just income and excluding capital growth. Contributions from the rest of the portfolio significantly improved overall returns. Having the core portfolio in place producing a steady income stream will also likely reduce behavioral knee-jerk reactions, which could derail your long-term performance. There are many companies that could fit into this position.
Businesses that have a record of returning cash to investors and growing earnings steadily are the best, but companies that have a record of producing steady capital growth with no income are also attractive. Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), Amazon (NASDAQ:AMZN) and Fairfax Financial (TSX:FFH) are great examples. Stocks such as Altria (NYSE:MO), Reynolds American (NYSE:RAI), IBM (NYSE:IBM), Coca-Cola (NYSE:KO) and American Express (NYSE:AXP) could all be considered for the income and growth part.
Overall, even though many professional investors prefer a concentrated portfolio, for the average investor this approach is not sensible. To reduce overall risk while at the same time maximizing the benefits from concentration a core and satellite approach might be the best tactic.
Disclosure: The author owns shares in IBM.
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