Position sizing is one of the most contentious topics in investing. Trying to decide how to weight the positions in your portfolio is not an easy process and, like all investing, there is no correct answer.
Investors have two choices when deciding on portfolio concentration; either a highly concentrated portfolio or a well diversified portfolio.
It seems the jury is out on which choice is the right one. Some of the world’s most famous and successful investors advocate a concentrated portfolio with significant positions. On the other hand, there is a wealth of evidence suggesting the average investor cannot pick stocks and should, therefore, not try. Instead, the average investor should just buy everything.
The deciding factor between these two approaches is, in my opinion, time. You can (or should) only use a highly concentrated portfolio approach if you have plenty of experience and have time to extensively research your positions.
Time is the key to outperformance
Warren Buffett (Trades, Portfolio) made his fortune by using a concentrated portfolio approach. Since the beginning of his career, he has always followed the mantra of devoting the bulk of his portfolio to his best ideas. Charlie Munger (Trades, Portfolio), Seth Klarman (Trades, Portfolio), Carl Icahn (Trades, Portfolio) and Mohnish Pabrai (Trades, Portfolio) (to name a few) have also advocated this approach (Benjamin Graham did too, but it was by accident). All of these investors are highly successful in their own right, but the factor linking them all is time and focus.
By devoting their lives to researching and evaluating stocks, they have been able to pull out their best ideas and go all in. Icahn is the one exception, but his ability to unlock value as an activist is arguably similar.
Before investing in Coca-Cola (KO, Financial), Buffett reportedly read 100 years worth of the company’s annual reports, a massive undertaking. This position has since made him billions, but it is dumb to suggest any ordinary investor could replicate this success because they just do not have the time. Even the top Wall Street fund managers do not have this much time. Between meeting with investors, meeting with analysts, general administration, marketing and other company analysis (fund managers would struggle to keep investors if they just made two or three huge bets, so they are forced to divide their time) there is no time to do 100 years worth of research themselves.
Using the concentrated Buffett approach requires sacrifice, focus, permanent capital and experience. For 99% of the world’s investing population, being able to devote the time and effort to stock research to make sure a concentrated approach is beneficial just is not practical.
That said, nothing is stopping you from having a concentrated portfolio if you wish. But if you have not done your research, using such an approach will, more often than not, end in disaster.
Diversification
There are plenty of investors who have racked up an impressive record of success without having a concentrated portfolio. Except for Peter Lynch, who had superhuman powers of endurance, enabling him to visit all of the companies he owned, most of the best-performing diversified investors have followed a quant-style strategy, seeking out investments that have similar qualities.
This process can be streamlined through a checklist or screener and involves much less effort than the concentrated approach. It also produces results; maybe not Buffett-style results, but there are plenty of investors out there who have successfully used diversified portfolios to outperform over the long term by seeking out the market’s best quality, growth or value stocks.
So overall, I believe the only investors who should be using a concentrated portfolio are those who have time to truly understand the businesses they own -- an approach not suited to everyone. It takes time, effort, focus and discipline to use this tactic successfully without blowing up.
Disclosure: The author owns no stocks mentioned.
