Wednesday, October 23, 2013

Fool’s Wisdom # 2: One, Few, Many or All??

No framework on portfolio construction can be developed without first choosing between the camps of concentration and diversification. In this second, of a four part series, we discuss the subject as we see it.

In the debate whether one should take large percentage positions on a single/group of stocks or always spread out one’s bets, the oracle of Omaha puts his weight firmly behind concentration. Early in his investing career, he is famously known to have wagered some 40% of his partnership capital in a single position viz. American Express. While we have no way to verify this, we read somewhere that a study of his portfolio revealed an average of 73% held in the top 5 positions over the years. He has also been quoted as saying “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Meanwhile, Buffett is not alone in his belief. Giving him company are the widely respected minds of Keynes, Soros and our very own Rakesh Jhunjhunwala.
No wonder then, that a large number of investors unquestioningly embrace concentration as the right way of life. We have come across investors who are quite comfortable holding only 2-5 stocks in their portfolios. Infact, a few investors we have high regard for, have at times had 50-70% exposure to a single idea.
We however remain confused as we sense outsized bets in portfolios as an outcome of various biases.
It is not that serious investors build these positions without doing a fair bit of primary and secondary research. However, it is possible that this process of ‘deep dive’ gives them a false ‘illusion of control’. They think that they are in a better position to control the future since either the management is a friend or they know the business like the back of their hand. In reality however, while solid research and an intelligent mind map can improve your understanding of a business and associated investment risks, the only way you can tell the future with certainty is if you are a good astrologer. And unfortunately we do not believe in the science of astrologyJ. What is true for Berkshire Hathway coming from a position of management control may not be true for a minority shareholder unable to influence management decision making.
Secondly belief in high concentration could also be a result of the bias of survivorship. Everybody sees the riches produced by a few using this approach while choosing to ignore the countless millions who undoubtedly perished following this undeniably riskier path. While bucket loads of books have been written about star managers, we do not remember reading about wannabe star investors who did not make it due to their concentrated portfolios since the story was probably not worth telling.
Further, it can be argued that extreme concentration is an outcome of our need for instant gratification. Who wants to toil the difficult road to riches through diversified holdings, when it can all be possibly attained in a short while?? It possibly also has something to do with the basic construct of the brain which is the laziest human organ. Why track so many companies, results, annual reports, regulations etc., when you know that you are sitting on a goldmine?
Critics of diversification on the other hand argue that more the number of decisions, more the chances of error. It is said that even the ‘best’ investors get no more than 7-8 out of 10 decisions ‘right’. Wealth creation through a diversified portfolio thus automatically demands that the investor needs to get more number of calls right.
The other risk diversified investors grapple with is the risk of ‘over diversification’. Very often in their search for ‘safety first’, they end up with a huge number of stocks (sometimes more than 100!!) rendering their portfolios both unmanageable and immobile J at the same time.
Equally eminent minds of Benjamin Graham & Peter Lynch have been votaries of sticking to spread out diversified portfolios. To quote Nassim Taleb from the Black Swan The inability to predict outliers implies the inability to predict the course of history”. The simple thought being that NOBODY fully knows what lies tomorrow. So stop trying to imitate astrologers and stop taking undue risks. Maybe highly concentrated investors in ‘quality’ businesses like MCX, Yes Bank and to some extent Titan would currently be appreciative of Taleb’s intellect.
A Matter of Choice
While we realize that concentration or diversification will always be a matter of personal choice and risk appetite, we think concentration is a luxury of the rich man rather than just about average individuals like us.
Answering the following question might help one develop a framework towards judging the risk / rewards from concentration.
Q: What best describes your goal for equity investing (choose one)
  1. Equities are an important part of my overall investment basket which I hope will help me meet my goals over my lifetime. (Absolute returns matter) 
  2. I invest in equities with an aim to beat the market (Focus is on relative returns)
  3. Equities are part of my overall wealth. I have sufficient alternate investments that help me meet my goals. (Equity gives me a high!!!)

If you have answered (2) to the above question, you are most likely to have an orientation of an institutional investor and therefore this debate is largely irrelevant. You have no choice but to start with the benchmark and add/subtract a few basis points of weight here or there. In our view, investors managing their own wealth would be ill advised to attempt to walk down this path. There is no point in coming first in a race if you don’t finish it!!
Like for us, we suspect that for most readers (1) would be the most appropriate choice. In our view those dependant on their investments for meeting their long term goals have no choice but to build diversified portfolios. While diversification can surely be accused of leading to sub optimal returns at times and reducing one’s odds of getting rich quickly, it is still the only way to go if you cannot afford ‘financial death’. Chances are that bad decisions will mostly succeed at injuring, as compared to killing you!!
That leaves concentration as a relevant option only for those making choice (3). If you are in it primarily for the ‘high’ then honestly anything goes as long as you can ‘sleep’ with it.
While, we have set for ourselves a maximum single position size limit of 10% (don’t ask us where we got that number, honestly we don’t knowJ. Its probably just a well rounded market anchor), we must confess that we have never dared to go beyond 6-7% (probably suggesting that we risk losing our sleep if we go higher). Likewise to protect against over diversification, we think that if we are not confident enough to build at least 2% in a given idea, it is not worth the effort.
We are happy to drive slowly if it means improved chances of reaching our chosen destination. We think to survive in markets, it is important to avoid the big mistakes than chase multi-baggers, as also pray for good luck (more about that in the next continuation post in this series). Sorry WB, even at the risk of being called ignorant, we would rather go with Taleb on this one!!

Best of manufactured Luck !!


  1. Good one Abhinav/Niren

    I generally restrict my exposure to most of the situations to below 5% for lack of experience and confidence...Though I have made couple of exceptions few times. Is there any situation where you guys will be comfortable in betting more than 10% either in a single stock or bunch of stocks but on the same investment theme.....

    1. Hi Anil,
      Generally for a specific stock the 10% rule stands and we haven't encountered any situation till date where we have gone beyond 10%. At a theme level, it is all dependent as to what one defines as a theme. We are still debating about should one look at some sector level cap as well given that certain black swan risks apply to the sector as whole.

  2. It is difficult to have concentrated protofolio for most of us (protofolio with more than 25-30 % allocation to single ideas). Nowdays market are almost efficient and only in cases of extreme uncertainty stock prices get undervalued based on current known information otherwise in most other cases stock prices is defined upon future events which prediction is difficult for any investors. I have two demant account in one i have protofolio of around 25 small-midcap stocks which has never fallen below its buying price in last 3-4 years but have always given good return and generally tend to outperform popular indexes. This protofolio i never track closely (even i am not aware about latest quaterly result for most of them) but once in a while remove negative return stocks either with existing positive return stocks or new interesting ideas and it has work well for me. In another protofolio i keep changing my stocks and recently have highly concentrated protofolio. Highly concentrated protofolio help you learn better about the company and behaviour of the stock market in general but good return (you need good luck more than anything else) mostly depends upon future events/results. I have observed that even great looking companies stock price movement can go in opposite direction from our anticipation atleast in short to medium term irrespective of any fundamental analysis.

  3. Nice post. A few queries-
    Do you buy all the desired level at one go? If not, then how you allocate- you buy after some say every 10% price drop or add after good quarter & reduce after a bad one?

    1. Thanks JK,

      We don't have any fixed rules on this. The basic thought being that the idea should be worth atleast 2% min and 10% max. How to go about the buying could depend on one idea to the other.

  4. While the framework provided in indeed useful, the presence of a meaningful capital base i believe is extremely important. Sans which diversification could lead one nowhere, especially when the objective is to make it big in the markets. RJ would not have been RJ if he didnt take big bets in the markets, would he??...Nor would WB be the legend of equity markets....I am not sure about WB but i think RJ would have taken huge leveraged bets as well at the start of his career.....Needless to say that the big bets would require very high degree of conviction in the idea which would entail thorough research, understanding and vision about things to unfold going forward....

    1. Thanks Abhishek for sharing your thoughts.

      In our case the objective is first to reach our goals and then to make it big, if possible, in that order. While we would be unhappy if we did not make it 'big', we would be completely devastated if we were not able to meet our goals. Thus we would aspire for stage 2 when we get past stage 1. And let us assure you, we are far from getting there :)

      Also as mentioned in the first post in this series, we are wary of high conviction. As we spend more time in markets, we are infact forced to be less confident of our abilities to foretell the future.

  5. Good post. One question.
    Do you track the allocation on cost basis or current market price basis?
    How to deal with a situation, when an initial allocation of say 5-10% grows to become 20-30% of the portfolio ?
    Do we let the winner keep growing, or prune it on a timely basis to reap the benefits of a winner ?
    Will love to have your guidance on these points.

    1. Thanks Raja for the encouragement.

      We have no guidance to offer, only OUR personal opinions. The question you have raised is an extremely important, yet tricky one. While we are ourselves struggling to come to a conclusion, we hope to share where we stand on the debate in the final part of this series as we build further on our investing framework.

  6. Nice post. I really liked how you guys have brought out 3 critical points to remember while you build an equity portfolio. Just wanted to share something that I read recently - WB bought GEICO at the beginning of his career and had a 75% allocation ($9800 total portfolio). He made a lot of money (could be that he knew only that company and that we was lucky). Most important the company got into some trouble in 1970 and stock went down 95%, By that time WB (just an investor earlier) has floated Berkshire. So i agree concentration is for the rich people..

    1. Thanks Amit for sharing your thoughts..Cheers and safe investing!!