A subject that investors often ask me about is position sizing within a portfolio. Though many investors finding some sort of middle ground, there are two primary opposed approaches to this:
- Concentration
- Diversification
Diversifiers
Diversification is well supported by finance theory, and almost all studies find that it is beneficial to diversify as much as possible (it is one of the few "free lunches"). It is often argued that the benefits of diversification start to fall off after buying about 20 different equities. This is widely regarded as gospel, but it is a shortsighted conclusion. It can be very, very beneficial to diversify beyond 20. It just doesn't help to add the same S&P 500 (SPY, Financial) indexes. But that's an entire subject of its own.
Extreme diversifiers invest an equal amount in each idea. Sizing investments evenly works under a few circumstances:
1) The investor still has much to learn and is not yet an outperforming investor. This will likely limit underperformance as your portfolio looks more like the market.Ă‚
2) The investor is able to generate alpha with their stock picks but unfortunately, they don’t know their terrific ideas from their average ideas.
The second condition is unlikely to be satisfied because it involves a similar skillset. It is best to try to work harder on differentiating between ideas. It will be much easier than raising the average level alpha on all one's stock picks.
Diversifiers are more common among bond investors where risk control is paramount, and investors tend to dislike volatility with a vengeance. True diversifiers are extremely rare. Some diversifiers establish positions in one size but afterward don’t meddle too much with their selections. This is approach allows for a survival-of-the-fittest dynamic to take place within a portfolio. A famous investor who uses this dynamic is Horizon Kinetics' Murray Stahl (Trades, Portfolio).
Over years, the truly great companies start making up an ever-greater percentage of a diversifier's portfolio. Most people rebalance as their Amazon (AMZN) or bitcoin (BTC-USD) positions get out of control. There’s something to be said for not doing so, though. Perhaps the market is the superior judge of ascertaining value, and they need to stick with those companies that turn out to have a durable competitive advantage as evidenced by years if not decades of strong performance.
Concentrators
Concentrators buy only a handful of stocks, securities or assets. Examples of investors who take this approach are Bill Ackman (Trades, Portfolio), Mohnish Pabrai (Trades, Portfolio) and Charlie Munger (Trades, Portfolio).
Activists often take a concentrated approach because they are so engaged and so actively involved with their positions that two things happen: Costs per position tend to be higher, and they ensure that their activist alpha is not diluted away by many passive holdings. An investor in an activist fund can diversify away from the concentration risk by spreading theur bets over different managers.
The common-sense reasoning for concentration is that investors' really great ideas are very rare. If you have a truly fantastic idea, you need to bet big to maximize profit.
It makes sense that investors will do better if they bet big on their best options, but people also often use the Kelly criterion to prove this. The Kelly criterion calculates how large a percentage of bankroll an investor should bet on an opportunity given a certain edge. It isn’t directly applicable to the stock market, but messing around with a Kelly calculator will give an idea of how important it is to bet big when there is a large edge to maximize return.
But the volatility of a profit-maximizing strategy is mind numbing, and professional gamblers (who can usually apply the formula more directly) rarely bet “full Kelly” because they will go through bankroll swings that are unbearable to most people, even this risk-seeking group.
Benchmark huggers
Finally, there are the benchmark huggers. This is a subset of the diversifier. This type is only found among professional fund managers. They are typically among the worst type of active fund manager you can invest with. They base their portfolio on the benchmark but overweight or underweight positions according to their views. This ensures that they don’t lag the benchmark too much even if their views turn out to be wrong (meaning it isn’t showing much confidence). Active managers with the highest active share (deviation from the benchmark) tend to be much better managers.
Conclusion
There are many different flavors of concentrating in only a few stocks like Charlie Munger (Trades, Portfolio) or diversifying across thousands of stocks like Jim Simons. Nearly every investor tilts their portfolio slightly toward better ideas, but some just don’t rebalance often. The better investor you are, the more you should consider concentrating. However, there are also other considerations, like the largest possible loss you would be able to sustain without abandoning your long-term strategy.
Both holding many stocks and holding a few stocks can work, but which approach an investor takes should probably be related to how they achieve alpha. Doing it by deep research or engagement works better with a more concentrated portfolio. If they generate alpha by finding pockets of inefficiency in the markets or use the Mauboussin approach of identifying the one thing the market doesn't know, they could be better served holding more stocks.
Something I don't love is when people hold eight stocks and weigh equally, constructing a passive portfolio of their best ideas. If you have the skills to pick eight stocks that offer alpha, you should be able to improve on that strategy. It's okay as a first step, but then take step two: Select more than eight stocks that offer alpha, and differentiate based on the amount of alpha they offer.
Read more here:Ă‚
Portfolio Strategy: Diversification Versus ConcentrationÂ
Richard Pzena Interviews Joel Greenblatt at Benjamin Graham ConferenceÂ
Bill Nygren on the Changes in Value Investing and Why Alphabet Is UndervaluedÂ
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