If you are an investor and you want to optimize your stock market returns,
it isn’t enough just to pick the right stocks.
You must also know how to combine different stocks into a portfolio
to maximize potential upside and minimize potential downside.
You want to diversify – meaning reducing your risk, but you don’t want to diworsify
– meaning reducing your investment returns.
How many stocks that you need in your portfolio to accomplish this goal is a question that has
tormented investors for centuries.
Luckily, Warren Buffett has got us covered on this topic,
but he thinks that most investors tend to get this one wrong, so listen up.
We think diversification - as practiced generally - makes very little sense for anyone
that knows what they’re doing.
This is the Swedish Investor, bringing you the best tips and tools for reaching financial freedom,
through stock market investing.
First, let’s have a look at how many stocks Warren Buffett held in
the beginning of his investing career and compare that to his current portfolio.
In 1941, an 11-year-old Warren Buffett purchased his first shares.
He bought three preferred shares of a company called Cities Service,
for a total of $114.75.
As his then net worth was $120,
he went pretty much all in.
Not much diversification to talk about.
However, a few years late, when Buffett was 19, his mind would change a bit.
This was the time when he read The Intelligent Investor,
and later went to Columbia Business School
to learn value investing from Benjamin Graham.
Graham operated an investment partnership called Graham-Newman,
and in 1951 this partnership had more than 100 different positions in its portfolio,
although it was quite top-heavy.
Buffett thought “maybe a single stock is too little”
and so he diversified to seven holdings.
And much like Graham, he decided to be top-heavy.
You will find opportunities that, if you put 20% of your net worth in it,
you’ve wasted the opportunity of a lifetime.
You know, in terms of not really loading up.
In January 1962 Buffett had recently become a millionaire through his own investment partnership
– Buffett Partnership Ltd.
Quite little is officially known about the positions of the partnership,
but Buffett hinted towards his portfolio allocations a couple of times:
In 1962 he stated:
We usually have fairly large positions (5% to 10% of our total assets)
in each of five or six generals
[which was what Buffett called one type of investments in the partnership],
with smaller positions in another ten or fifteen.
In 1966 he said:
We probably have had only five or six situations
in the nine-year history of the Partnership where we have exceeded 25%.
And also…
We presently have two situations in the over 25% category
- one a controlled company [Berkshire],
and the other a large company [American Express] where we will never take an active part.
From this, I think that we can safely conclude that, back then – Buffett liked to stay focused.
However, if we fast forward to today, we wouldn’t get the same picture.
Warren Buffett owns more than 40 listed companies and more than 50 wholly-owned operating subsidiaries.
It is quite difficult to state what his current portfolio looks like,
as most of these companies aren’t listed, but that won’t stop me from trying.
According to my calculations, and you can find some assumptions in the description of the video,
Warren Buffett’s current portfolio looks like this.
Still quite top-heavy, but not at all as concentrated on a few companies as he was back in the days.
Does this mean that Buffett thinks that a 100-company portfolio is better than a 10-company portfolio these days?
That he no longer likes to concentrate his portfolio now that he is older and wiser?
We’ll never get a chance to do that working with the kinds of money that Berkshire does.
We try to load up on things.
And there will be markets when we get a chance to from time to time,
but very seldom do we get to buy as much of any good idea as we would like to.
So, no, Buffett would love to operate a concentrated portfolio today too.
It’s just that, when he is only looking at the elephants of the business world,
he seldom finds that one of them is both understandable and undervalued.
But you and I do not need to limit ourselves to the elephants,
so let’s talk about four rules of thumb which Warren Buffett would use to determine
how many (or how few) stocks you should have in your portfolio.
By the way, the logic applies to other types of assets too, such as real estate or bonds.
The first thing you should consider is this:
1. Are you a know-something investor?
Diversification is a protection against ignorance.
I mean, if you want to make sure
that nothing bad happens to you relative to the market, you own everything.
There’s nothing wrong with that.
I mean, that is a perfectly sound approach
for somebody who does not feel they know how to analyze businesses.
If you know how to analyze businesses and value businesses,
it’s crazy to own 50 stocks or 40 stocks or 30 stocks, probably.
Brokerage firms must inform their customers that: “Your capital is at risk”.
Every company in the stock market is in no way a safe bet
and it is possible to roll a few snake-eyes in a row.
A know-something investor understands which die he is rolling when he is investing,
or at least he has an idea of what it looks like.
The know-something investor has done things such as:
- Looked through the financial statements of the companies he invests in
- Researched the management and owners of the companies
- Understood who the main competitors of the industries he is in are;
and - Compared the price of his investments to other opportunities in the stock market
The more knowledge you have about individual companies, the less diversification you need.
And conversely, if you don’t know these things about companies,
it is better that you purchase a wide selection of securities, probably through an index fund,
because you frankly do not know what kind of die that you are rolling.
Note that this can vary from industry to industry or country to country by the way,
you might be very knowledgeable about American stocks but not so much about Swedish ones.
As introspection of this kind is really difficult to make, a good proxy for how much you know
is how much time you spend on researching stocks each week.
Index funds is the best option for people who cannot commit too much time to security analysis.
As Buffett said in 1993:
By periodically investing in an index fund, for example,
the know-nothing investor can actually out-perform most investment professionals.
Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.
2. Are you investing in risky assets?
Even at the roulette tables, where the casino has a mathematically computable edge,
diversification is needed.
Therefore, there’s a limit to how much you are allowed to bet there.
Casinos know that a string of losses can lead to bankruptcy – 0
– and no previous outstanding returns can compensate for that.
The riskier the bets that you are taking are, the more diversification you’ll need.
Risk with us – well - it relates to several possibilities.
One is the risk of permanent capital loss.
And then the other risk is just an inadequate return on the kind of capital we put in.
It does not relate to volatility at all.
The stock market is obviously not as quantifiable as the casino.
In terms of “riskiness”, what you need to watch out for are securities
where if you are wrong, you are likely to lose everything in that holding.
Here are a few such situations:
- Startups - Bankruptcy cases
- Industries with a lot of flux;
and - Pretty much anything involving leverage
You should also watch out for correlations between your holdings.
For example, even if your portfolio consisted of 20 different horse carriage companies when the Ford Model T arrived,
your diversification wouldn’t help you much, you would have been smoked anyways.
3. Are some opportunities much better than others?
And to have some super-wonderful business
and then put money in number 30 or 35 on your list of attractiveness
and forego putting more money into number one, just strikes Charlie and me as madness.
If you are a know-something investor you should be able to judge the attractiveness of individual opportunities,
not everywhere, but at least within your circle of competence.
For example, say that you’ve found companies which you think are likely to return the following.
Given this scenario it would make sense to load up on your top five ideas.
Adding an equal stake of company number six through ten to your portfolio will reduce its expected returns,
and you will be, as was hinted at in the beginning of the video, diworsifying, a term stolen from Peter Lynch.
Moreover, you should invest far more in your best idea than the rest.
Much like Buffett has done with Apple & BNSF today, or like he did in 1951 with Geico.
4. Can you earn it back?
You will see things that it would be a mistake if you’re working with smaller sums
- it would be a mistake not to have half your net worth in.
This is the fourth rule of thumb
– the less capital that you are working with the fewer stocks you need.
It depends on where you are in your investment career and how much you earn.
For example, if you only have one month of salary to invest,
you could go crazy and bet all of it on a single stock, heck, I wouldn’t even care much if you said
you’d bet it all at the roulette table (although that is a stupid idea)
but at least you will get it back the next month.
When we are starting to talk about sums of money which takes a couple of years
to earn back through your everyday work though, then you must really start to consider diversification.
An extreme case would be if you’ve just inherited a large lump-sum of money.
Alright, so you should concentrate your portfolio more if you:
- Are a know-something investor
- Are buying assets that have a low risk of adverse outcomes
- Expect a large difference in returns among the opportunities you’ve found;
and - Can replace your capital fairly quickly through income
As you may have guessed – this is not a precise science.
But an investor will have a distinct advantage when he is aware of what path his thought process is following.
I’ll use myself as an example to illustrate how one can benefit
from these rules of thumb practically.
I think this will be more instructive if we start …. here.
I do have a list of opportunities that I consider for investment,
and I do rank them quantitatively based on both quantitative and qualitative factors.
I’m not sure that you must do something like this explicitly,
but at least implicitly you need to have a ranking among your ideas.
Around number 18 on my current list there’s quite a bit of a drop,
so I’d probably only consider the top 18 companies for investment.
I’m not a know-nothing investor, but I’m not a full-time investor either.
Making these YouTube videos is something that I enjoy doing,
but it definitely takes some time from the investment process
I’d say that I can be fairly concentrated based on this, so let’s cut those 18 into 9.
Next, there’s quite a bit of risk in the kind of opportunities that I invest in,
but they are nowhere near that of a venture capitalist or someone buying companies in bankruptcy.
I think the allocation should remain unchanged based on that.
Finally, I’d say that the portfolio is still quite small compared to my current income,
and potential income, but not insignificant.
Therefore, I can probably concentrate a bit more,
perhaps I should focus on 6-8 securities.
Turns out that I have 12 currently,
so I think I learned something myself by making this video.
The video which I’ve learned the most by making is probably this one though,
a video with lots of meat covering Warren Buffett’s 25 most important investments of all time.
If you think that you could learn something from that too,
then click on the video now.
Cheers guys!