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)
- 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)
- I invest in equities with an aim to beat the market (Focus is on relative returns)
- 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 !!