Getting above average returns in the stock market is not only a function of picking the right stocks
It is also a function of structuring your portfolio in a clever manner
Warren Buffett is the greatest investor of all time,
so I think he is the best subject to study to learn about portfolio allocation. In this video
you will learn that his approach, which could be called "focus investing", differs a lot from what you might have heard before
and/or have been taught in school
This is a top 5 takeaway summary of The Warren Buffett Portfolio, written by Robert Hagstrom
And this is The Swedish Investor, bringing you the best tips and tools for reaching financial freedom through stock market investing
Takeaway number 1: Focus investing
Perhaps you noticed in the introduction
Since 1980, Warren Buffett has almost always had the top five companies of the portfolio of his company, Berkshire Hathaway,
representing more than 50% of the total
In 1990 they were almost 70% of the total, and this was at a time when the company had close to a $10 billion valuation,
or in other words, it had quite a large portfolio
This approach could be called focus investing. The essence of it is this:
Bet big on a few stocks that are likely to produce above average returns over the long run
and stick with these stocks through short-term fluctuations
There are many advantages to this approach
compared to the ultra diversified portfolios that many of the money managers on Wall Street run these days
Firstly, it reduces costs
There are many things that are quite unpredictable in the stock market, but costs is not one of them
A focus portfolio reduces the costs of investing both in terms of transaction fees and in terms of taxes
The difference between running a high-cost portfolio and a low-cost one is
quite astonishing and you can learn more about this in my summary of The Investment Zoo
Secondly, it increases your chances of over performance
Before writing this book, Robert Hagstrom ran a simulation, testing how
3,000 randomly generated portfolios would perform during a period of 10 years
3000 portfolios with 250 stocks in each
3000 with 100, 3000 with 50, and 3,000 with 15 stocks in each
This study shows some interesting results
Among the portfolios with
250 stocks in each, the maximum returns of any portfolio during the period was 16% annually
Even this best of performing portfolios didn't over perform the general market in any significant way
Among those with 100 stocks the best one had 18.3% yearly returns
50 stocks, 19.2%
And finally, among the portfolios consisting of 15 stocks, 26.6%
So ...
Focus portfolios beat the market by significant margins much more often than diversified ones
Coincidentally, they also underperform the market to a significant degree more often when you look at it from a theoretical standpoint,
but I'll explain why this isn't necessarily the case in practice in the next takeaway
Thirdly, it reduces risk
Yes - reduces
When risk is defined in the only manner that risk can intelligently be defined in,
it lowers the risk of your portfolio to use focus investing. You learn why in takeaway number 3
Takeaway number 2: The higher the probabilities the bigger the bets
According to Warren Buffett:
"Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain."
"That is what we're trying to do. It's imperfect but that's what it's all about"
Inevitably, some stocks will have higher probabilities for above average returns than others. As a focus investor,
you should tweak your portfolio accordingly
Let's get back to the animations from the intro of the video again
The outstanding returns of Warren Buffett's Berkshire Hathaway can, to a large extent,
be attributed to the fact that he was willing to bet big when the odds were
overwhelmingly in his favor
Berkshire wouldn't have been Berkshire without large bets in companies like GEICO, American Express, Coca-cola,
Wells Fargo and BNSF Railway
An interesting corollary to the fact that you should bet bigger the higher the probabilities are,
is that you should always use your current best holding as a
benchmark for buying new ones
For example,:
If you own Apple currently and you've calculated that the company should be worth something
like two times more the current price of the stock, you shouldn't add companies that are worth less than that to your portfolio
Quite frequently, the best investment to make is to double down on something that you already own
On Wall Street, just the opposite approach is used
If one holding advances to become a large part of their portfolio,
they typically sell parts of that company to invest in other companies, but this is madness
Trading away your largest holding just because it has come to dominate your portfolio is
very similar to saying that Barcelona should trade away Leonel Messi because he has become so important to the team!
Crazy!
According to Warren Buffett's right-hand man Charlie Munger,
not using probabilities for investing is like being a one-legged man in an ass-kicking contest.
You're giving away a huge advantage to everyone else!
When deciding how big you should bet you can use something called the Kelly Formula,
which you can learn about in my summary of the Dhandho investor
Takeaway number 3: Is focus investing super-risky??
Takeaway number 4: An alternative ..
Maybe I should elaborate a little bit ...
I bet you've heard from many different sources that, as an investor, one must diversify
Diversify diversify diversify
The one universal rule that idiots in finance know is diversification. It's the only free lunch. You gotta diversify.
Diversification is crucial ... and the more diversification you can get the better
Single stocks are a bad place to invest money ... You're much better off to be spread out and well diversified
And it isn't such a bad idea
Even Warren Buffett himself
admits that, for the know-nothing investor, it is a great option to periodically invest in index funds
These will give you a high degree of diversification and you are pretty much guaranteed to receive the average market returns
But the ambitious investor should ask himself this: am I satisfied with average returns?
Can I do better?
Let's look at why someone would diversify
Diversification means buying many different stocks so that a single one of them, or just a few of them,
can't have a large impact on the portfolio
And this is inevitably true - if you own 100 companies in your portfolio and you bet
1% of your capital in each of them,
you cannot lose more than 1% on any single company, even if this company ends up in the worst bankruptcy in history
If you own 20 stocks in a similar fashion, you stand to lose 5%
If you own 10 stocks, 10%, etc
The opposite is of course also true - in a portfolio with 100 companies, each representing 1% of the total,
you cannot gain more than 1% should any single one of the stocks in it double
20 stocks and you can gain at maximum 5%. 10 stocks and you can gain 10%
What diversification gives them is reduced volatility
Your portfolio will fluctuate
less and less the more companies you add to it, given that the stocks of these companies do not move in tandem, of course
But risk is not volatility!
If you portfolio fluctuates a lot, who cares?
Is this a bad situation?
Not necessarily, because it probably means that you can buy more of the great companies that you already own at bargain prices
Is this a bad situation then?
Well, few would question that, but it could mean that your companies are overvalued and that some of them should be exchanged for lower valued ones,
or it could simply mean that your companies are doing great
Risk is:
Not knowing what you are doing
If you add an additional 90 companies that you don't know much about to a portfolio of 10 companies,
which you do know a lot about (just for the sake of diversification) you have just increased your risk not decreased it
Not knowing enough about 90% of what you own, how can that possibly be a reduction of risk?
Risk will decrease the more knowledge you have, and you have the possibility of having more knowledge about your portfolio
the fewer companies that you have in it
As I said earlier:
Takeaway number 4: An alternative portfolio benchmark
Perhaps you noticed in the introduction, the portfolios that I presented
represents the earnings of Berkshire Holdings as a part of total earnings and not the market values of the holdings as part of the total
The reason for this is twofold:
Firstly, it was difficult creating these illustrations as it involved a lot of assumptions and guesstimates
It would have been even more difficult
if I tried to convert Berkshires wholly owned subsidiaries into market values
So yeah, the first reason is because I was kind of lazy
Secondly -
earnings is the ultimate yardstick of the intelligence investor
Warren Buffett says the following:
"The goal of each investor should be to create a portfolio
that will deliver him or her the highest possible earnings a decade or so from now"
As discussed in the last takeaway - focus investors will have portfolios which fluctuates a lot
To be able to handle this mentally, you must become a master bump ignorer
Take the returns of some of the greatest investors of all time - such as John Maynard Keynes,
Warren Buffett, Charlie Munger, Bill Ruane and Lou Simpson
Notice how they have performed compared to the S&P 500 over the years
Their returns have fluctuated a lot. Sometimes they've underperformed the market over several years!
But over the long run, their portfolios have had huge returns
One reason why they were able to stay the course
even during times of turmoil is because they
focus on the companies that they own and not the price that the market sets on these companies
One way to do this is to look at earnings instead of market values
Earnings will fluctuate much less, and over time, they will decide how successful you are as an investor
"The market may ignore business success for a while, but eventually, it will confirm it"
Takeaway number 5: The Warren Buffett principles
You've learned about how to concentrate your investment portfolio around great businesses, but what actually makes a superior business?
I've made a whole playlist on what Warren Buffett thinks about this subject that I will link to at the end of this video,
but here is a short checklist of some of his most important principles:
Business principles:
Do you understand the business?
Is the history of the business consistent?
Does the business look promising in the long run?
Management principles:
All the managers rational?
Are they honest with shareholders?
Do managers show independence of thinking?
Financial principles:
Focus on return on capital
Find out what the "owners earnings" are
Look for high profit margins
One dollar retained in the business must always produce more than one dollar of market value
Market principles:
What is the value of the business?
Use a margin of safety. Buy the stock at a price which represents a comfortable discount to the value of the underlying business
When you are trying to pick great companies on your own, there are two ways to go about this
You can go from left to right - first looking for great businesses
then considering the management, then the financials and finally the price
With this approach,
you only look at the price of a company,
for example, if you first confirmed that it's a good business with good management and good financials
The other approach is that you start with the financials, and then go from left to right
This approach might be quicker as you can sort companies out quickly using a financial database like
screener.co, CapitalIQ or borsdata.se
For more about Warren Buffett and his investing approach, head over to my playlist of Warren Buffett books. Cheers guys!