One of the perennial questions in the minds of investors is about the optimum size of a portfolio or how many stocks should one hold in one’s portfolio. Put another way, should you have a concentrated or a diversified portfolio? There are lots of arguments for and against each option. Too few stocks make the portfolio highly risky. So, academics advise you to diversify, summed up in a statement like “Don’t keep all your eggs in the same basket.” There is no free lunch in financial markets but diversification comes closest to something like a free lunch.
However, most successful investors say no to this free lunch; they run highly concentrated portfolios. Among the many folksy and memorable comments of Warren Buffett is this: “Keep all your eggs in one basket, and watch that basket closely.” Concentrated Investing: Strategies of the World’s Greatest Concentrated Value Investors by Allen C Benello, Michael van Biema, and Tobias E Carlisle goes into this topic by taking us through the stories and performance of several successful investors in eight chapters. These include: Lou Simpson, John Maynard Keynes, Warren Buffett, Charlie Munger, Kristian Siem, Grinnell College, Glenn Greenberg and three mathematicians, John Kelly, Claude Shannon, and Edward Thorp, in one chapter.
All of them have been thoughtful investors and have recorded fantastic long-term returns by staying focused on just a handful of stocks. How many? On an average, it was around 10-15. For a long time, Charlie Munger believed that he should have just three stocks in the portfolio. Separately, academics have tried to simulate average returns from portfolios of different sizes and have found that beyond 20-30 stocks, diversification stops delivering value.
The book takes us through the concentrated portfolios of successful investors. But most of them were professionals. Four of them were linked to Buffett. Lou Simpson managed the investment portfolio of Geico Insurance, a Buffett and Munger company. Buffett and Munger themselves have spent a lifetime learning the techniques and nuances of investing. Buffett sat on the Grinnel College Endowment for many years. Keynes had spent a lifetime trading and investing (everything from the Indian rupee to Argentine bonds) and later managed funds for King’s College, Cambridge University Endowment and two life insurance companies. Kristian Siem, a Norwegian, was not into stocks but an investor in oil rigs who entered the business when he was in his early 20s.
The three mathematicians were not amateurs either. They were in touch with new tech entrepreneurs who created humungous returns; the rigour they applied to understanding statistical expectancy from stocks, position size and even market-timing was highly sophisticated. The central character of this pack was Claude Shannon, the creator of information theory, probably 20th century’s biggest scientific achievement that led to the digital economy we have today. Edward Thorp, his colleague in Massachusetts Institute of Technology, was banned from Las Vegas when he and Shannon, dressed in false beard and dark glasses, went around beating the casinos in blackjack. John Kelly, a physicist who worked with Shannon in Bell Labs, focused on something crucial to returns: how much to bet on one position? None of these investors is a novice.
Concentrated portfolio is the output of investors discussed in this book. What went into creating them were some or all of these qualities: a clear understanding of bet size, intense research, a very long-term view while betting big and extraordinary behavioural control, since a concentrated portfolio can lead to higher volatility and large temporary losses. All this is almost tough for the amateurs.
Even if you decide to have a concentrated portfolio, you may want to vary your bet size. This is captured by Kelly Criterion the formula for which is f* = (bp – q)/b where f* is the fraction of the current bankroll to wager, where b is the net expected gains, p is the probability of winning, and q is the probability of losing. Interestingly, if you assume that you would treble your money (b=3) and the odds and 50:50 (both p and q are 0.5), then the amount to bet is 33% on a single stock. This means you should be buying just three stocks, exactly what Charlie Munger thought of buying for his portfolio. Buffett or Keynes did not use the Kelley Criterion; they used the core idea: bet less, bet on higher odds of winning odds and then bet big.