Concentration vs. Diversification
The beauty about the stock market is one can manage a portfolio however he/she feels like. Want to be stuck in front of computer and trade stocks all day? Go for it. One of the decisions any investor will have to make is how many stocks will be in the investment portfolio. A common trait among value investors who outperform the market by wide margins is they have concentrated portfolios.
Diversification
Before moving on, let me clarify one thing; there is nothing wrong with diversification. I have had a diversified portfolio ( 15+ stocks in my book) for a while now as my time for researching stocks was limited. There are plenty of value investors who diversify and outperform the market by a good margin. Walter Schloss comes to mind.
Some well known concentrators
- Warren Buffett/Charlie Munger - While Berkshire holds a great number of stocks, the majority of the stock portfolio is invested in big bets such as Coca Cola (KO), American Express (AXP), Washington Post (WPO) and prior to that GEICO just to name a few. It was Buffett’s sidekick Charlie Munger who turned Buffett into a more concentrated portfolio.
- Peter Lynch- The worlds greatest mutual fund manager held hundreds and sometimes thousands of stocks at a time. But as he confesses in his book(s), Peter Lynch had a couple of big bets and a ton of small bets so he could keep up with a company’s “story”
- Eddie Lampert- Once considered the next Warren Buffett as the price of Sears Holdings approached $200, Lampert made the majority of his wealth by betting big on the merger of k-Mart/Sears. I believe his cost basis is $1(I might be wrong on this) as he merged the two companies when K-Mart filed for bankruptcy.
- Joel Greenblatt- Probably never believed in diversification. Reading both of his books, Greenblatt constantly advocates making few but big bets. Before I get bombarded with e-mails about the magic formula strategy and diversification, Greenblatt does make seveal points as to hold 5-8 well researched stocks for greater returns. For those individuals who want to put their portfolio on auto pilot, follow the magic formula as layed out in the book.
- David Dreman- Also advocates a diversified portfolio in his books. But, he made good money by placing big bets in Fannie Mae (prior to its recent drop he bought below $5) and Altria
Pitfalls of concentration
- A more volatile portfolio.
- A blowup in the portfolio will be a major setback against the market
- You have to be VERY patient
Tools for concentrarion
- Time
- Time
- Time
- Knowledge
- oh yeah, patience
Quotes
I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over. - Warren Buffett
Put all your eggs in the one basket and — WATCH THAT BASKET.
Pudd’nhead Wilson, Pudd’nhead Wilson’s Calendar, Chap. 15
![[del.icio.us]](http://images.del.icio.us/static/img/delicious.small.gif){kind=small}
If you enjoyed this post, make sure you subscribe to my RSS feed!
- September 25th
Very well written. I tend to concentrate while a stock is cheap, but I have an overall allocation I work within.
Best Wishes,
D4L
That should read, “A common trait among value investors who outperform the market by wide margins is they have superior knowledge of the risk/return profiles compared to the rest of the market, or they have access to investment opportunities that the rest of the market does not (e.g., Buffett & Goldman).” This naturally leads to concentrated bets being preferred to diversification.
T.J: I could not have said it better
D4L: Great to see you have allocation “system” , mind sharing?
You must understand though, when it comes to characters such as Warren Buffett, people are quick to point fingers to the ripple effects of his decisions and the fact that he can create special deals because of his large capital base.
That being said, we all knew that he was building up and maintaining liquidity in his portfolio because like any good value investor, he saw that the market was well overpriced (Read The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend. Especially the section where he testifies to congress and his valuation of the market at the time). He wasn’t chasing returns like so many other managers that we continually see fail.
Through it all though, we must remember that these gentlemen that are legends and are followed by many, started out like us - very common. It was a solid foundation under a solid investing principle that allowed them to make a majority of good decisions and the ability to recognize their bad ones. I refuse to relate the isolated instances where these gentleman obtained good deals as a matter of luck, or bullying with capital and not the effect of years of quality decisions that put them in a solid position.