From the time I have started investing I have been diversifying my portfolio significantly holding 40 to 50 stocks with all positions under 5% of the portfolio. This is what they tell you you should do and this is what I did. Diversification is supposed to protect downdraft but what about upside? I really needed to pin down my strategy on diversification and concentration in my portfolio. Do I diversify, diworsify or concentrate.
I already have my asset allocation with fixed income and cash percentages to reduce market risk based on market valuation from market cap to gdp. The reason I pick my own stocks is to get alpha or beat the market not to match it. If I only want to match the market then I could get an index fund or a mix of index funds.
How will I beat the market if I don’t bet more on my high conviction businesses? If you have a lot of small holdings then you need to have made a lot of correct decisions to get Alpha and beat the markets. The key is how well I do my research and evaluation. If I do not have the skill to do this I should be getting the index fund or paying someone to invest for me.
There are strengths and weakness for both strategies:
- It is reasonable to expect a diversified portfolio to have protection against downside because of the small portions each investment will have less impact.
- If a company is found fraudulent and is falsifying their books they could drop a over 50% and if they were 25% of your portfolio it will obviously have a bigger impact on the portfolio than if they were 2%. Diversification would protect here.
- The same is true the other way though. If the company beats earnings expectations in a big way and they go up a lot then if you have 25% of your portfolio you will have a big upside to your portfolio. In this case concentration gets the nod.
- Having a concentrated portfolio with less holdings makes it easier track your portfolio for a do it yourself investor allowing you to know your equities well.
- The key is if you have a strong system and ability to pick stocks.
- Diligence on both managing market risk and business risk is essential to manage risk for a concentrated portfolio and protect you from not being diversified.
The community section of my online broker has an area they call the universe and it is dots that are plotted on a graph with the x axis being the return and the y axis the volatility. Each dot is someone’s portfolio and you can drill down on the dot to see the portfolio behind it. I found many of the portfolios that were getting better returns than me, with similar volatility, had 1 to 20 holdings and some bigger allocations to their top equities. So I looked at what the professional investors were doing.
Well known investors have two camps: some like George Soros and Joel Greenblatt have hundreds to over a thousand stocks with small portfolio allocations for even their top holdings. Others have single digits 6 or 7 to 40 stocks with the allocation of their top five account for anywhere from 40 to 80%. I looked at portfolios and found many of my favourites actually put a lot of their portfolio in their top five choices.
Here are the top five holdings percentage allocation from the concentrated gurus who I follow. (data from Feb 23rd, 2016 from GuruFocus and rounded down);
- Bill Ackman 79%
- Carl Ichan 64%
- David Tepper 42%
- Prem Watsa 89%
- Warren Buffet 58%
- Daniel Loeb 70%
- Dale Rolfe 39%
- David Einhorn 40%
In fact, of the top eight Guru performers since inception, only Jim Simons (he has the top returns) would be a highly diversified. Simons uses logarithms and computerized trading that I cannot begin to emulate as a do it yourself investor. The rest are more concentrated, many are from the list above – Tepper, Watsa, Buffet and Loeb.
So I have decided to concentrate my portfolio and am now reducing my holdings and working to increase the percentage of allocation to the remaining picks particularly the ones I have the conviction for. My desire to become more concentrated comes from checking on my online broker looking at the portfolios with similar risk that are beating me, studying well know investors, looking at my time and ability to track a number of equities and believing in the system I have.
Since last month I have dropped to 23 holdings from over 40 and 19 are actual equities with the others etf’s for shorting and fixed income. I find myself more confident in my picks and have the ability to stay on top of them.
If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your first choice.
Charlie and I operated mostly with five positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest.
In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express ( NYSE:AXP ) after the Salad Oil Scandal.
In 1951 I put the bulk of my net worth into GEICO
What is your experience with diversification or concentration? Please share your comments.
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