Preface
As you know, I have been an advocate of concentrated portfolio for quite some time now. Among friends, I used to refer each stock as a wife. The more you have the more the trouble! I’d say as you pick your life partner, you need to know the ins and outs of a business. You should know the nuts and bolts of the company, its management and the integrity of the management before you pick a stock. It’s better to own what you know the best. Now over to our curious case of diversified vs concentrated portfolio.
Diversified vs concentrated portfolio
Citing this Economic Times news article, one of my friends asked “Raj, all the investors mentioned in that article have more than 500 companies in their portfolios. So what do you say now about 500 wives?”
Good question. Which one would provide exceptional returns, diversified vs concentrated portfolio?
Burton Malkiel in his book A Random Walk Down Wall Street says-
Investors who select a portfolio of stocks by throwing darts at the stock listings in the Wall Street Journal can make fairly handsome long-run returns. What is hard to avoid is the alluring temptation to throw your money away on short, getrich-quick speculative binges.
So a basket full of stocks should give you market returns over the long term. However, where you will err is ‘heeding to stock tips and going after penny stocks!’
Concentration
Look at the billionaires you have heard about. Narayana Murti, Mukesh Ambani, Dilip Shanghvi, Lakshmi Mittal, Shiv Nadar, Azim Premji or US investors Bill Gates, Warren Buffett, Jeff Bezos, or Mexican businessman Carlos Slim or any other billionaire for that matter. What do they have in common? All of them have their fortunes tied to just one company or business. In fact Bill’s SEC filings reveal Bill to have left only with less than 3% stake in Microsoft after all his philanthropy. Still he is the number one billionaire in the world. It’s his ownership in Microsoft that propelled him to that spot and still places him there. Warren Buffett has almost all his wealth attached to just one stock, 38% stake in Berkshire.
Pros of concentration
If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West, Too much of a good thing can be wonderful.
–Warren Buffett
All businesses are not equally profitable and do not grow at the same rate. Hence if you want high returns, you need to concentrate on very good businesses that generate exceptional profits. To pick one such wonderful business, you need to know a lot about the businesses available in the market and then identify good and bad businesses among them. So first you need to know what you don’t know and must be willing to admit what you don’t know. Then learn on what you don’t know.
Read, read, and read books on investing. Try to stay two feet inside from the periphery of your circle of competence! I could hear you yelling “Come on Raj, it’s too much! I am already busy with my current job and can’t find time!” But yes, you have to. It’s your hard earned money. Nobody can be a better manager for your money than yourself. Moreover, you know stocks are the best asset class over the long term in terms of returns if you do it properly.
Diworsification
Too often investors throw money around like scattering seed, saying to themselves, “I’ll throw a little here and little there to see what happens.”
-Warren Buffett
Thus, if you want superior returns above what market offers you, you need to concentrate your portfolio with exceptional stock/s (businesses) bought at reasonable prices. Otherwise it will be nothing much than diworsification. I could hear you saying “those businessmen eat what they cook!” That’s why I say you should have 100% conviction in what you own. It should be a business that is managed by a management of sound integrity.
Therefore I replied my friend about the Economic Times news article I mentioned above:
“Don’t take to heart whatever you read. Just sit back and analyze the reality. Unless the portfolios are not revealed, it is just a folktale. Read, fantasize, smile, and move on.”
Cons of diworsification
Ok, let me elaborate slightly in detail.
I don’t know how much time of a day do you dedicate to spend with your wife and family. Only if you dedicate some time to your family members, you know their problems, needs etc., and can act accordingly. That’s how you express love, cherish relationships. I meant it with one wife!
Now come back to the 1000 stocks you own. I don’t know if you care to read annual reports of the companies you own, though not their quarterly filings. If you own a stock, you have to read its annual report along with the numbers to get a picture where that company is heading, to get an idea whether to own it or not.
Howsoever quick you may be at reading, I don’t think you can read an annual report in less than an hour. For 1000 companies, 1000 x 1 = 1000 hours. So you need to spend at least 1000 hours a year just to fondle your stock wives! 1000/24 = 41.66, that is a whopping 42 full days! Unless you do that, you won’t even be knowing whether one of your wives is having an affair with your neighbor or milkman! If you want to read quarterly reports, multiply that number by 4.
Now it’s a matter of choice for you to have 1000 wives and see them flirting around. You don’t have time for attending them. Or else you could really pay attention to all of them by just having a small, beautiful family and fondly care them.
Diversifying the right way
Okay, you are still not convinced but want to diversify. How should you diversify for superior returns then?
One stock at a time. For instance, if a very good business goes out of favor in the market, stock it up with all your resources and cash flows (without using leverage), as long as the stock is available well below your calculation of intrinsic value, even if it stays there for years. Once it is above intrinsic value, forget it. Your money has started compounding. Mind that you should be able to identify a good business, not a mediocre one, and a good management, not a shoddy one. Period. Over!
Keep loading your gun until another such shot is available next time, may be it could take 2 years, 3 years, 4 years; but wait for the fat pitch with the odds in your favor rather than the other way around. Mr. Market, newspapers, magazines, business channels, websites, investor groups and forums may keep tempting you “swing you bum,” but have patience like a Kingfisher. Once another wonderful business goes out of favor in the market, swoop down and scoop it up with all your energy with the policy as I said above. (By this time if your earlier stock is quoting at an exorbitant price, you may sell and bring in those resources too here to load up or leave it as it is if you find no reason to sell.)
By this way, build wealth over the long term, and you will be a rich man with tax free cash equivalent assets at your sunset years, that’s for sure.
Conclusion:
Only if you lack conviction and do not know what you are doing and are owning, do you diverse. If you are unable to do all the homework and is content with market returns, go for a low cost index fund. Else, keep all your eggs in one nest and watch that nest closely. Obviously your aim should be to build long-term wealth with equity and not get rich quick. Of course yes, you cannot produce a baby in one month by getting nine women pregnant!