Why strategic thinking is essential when it comes to portfolio management
In his chairman’s letter to Berkshire Hathaway shareholders this year, the billionaire investor Warren Buffett described his group’s investment portfolio as being like a “forest”.
Berkshire’s many and diverse businesses, he said, were its “economic trees”. Like any portfolio, it has an array of specimens (in Berkshire’s case there are vast numbers of them). They range in size from twigs to redwoods. And while a few trees are diseased and likely to die in the decade ahead, he said, “many others are destined to grow in size and beauty”.
This was Buffett hitting his poetic stride. He took the arboreal theme a step further by splitting the forest into five important “groves”. For Berkshire, the biggest of those groves is obviously insurance, which has powered the portfolio over decades. Others are its non-insurance businesses, equities, joint ventures and then bonds and cash.
Buffett used this analogy because he felt that onlookers often obsess about “mind-numbing” analysis of individual businesses, or trees. His point was that you don’t need to assess every single tree to make “a rough estimate of Berkshire’s intrinsic business value”.
Now to be fair, the read-across for regular investors isn’t all that straightforward. With Buffett’s resources, I’d hazard you could be fairly relaxed about the odd disaster or bad decision. Most of the rest of us quite rightly take those things pretty hard.
But the point still stands that, even though his portfolio is on a far greater scale than most, Buffett’s diversified approach lets him think strategically rather tactically. Taking a 50,000ft view means he can be sanguine when things don’t go right and focus instead on whether the overall campaign is paying off. This is where the lesson is.
Are we thinking strategically enough?
There was an update to some research recently about exactly how investors deploy funds when they’re building up portfolio holdings. The findings are quite subtle - and on the surface you might not think they’re that earth-shattering - but they echo this same idea of thinking from a portfolio perspective.
What the findings show is that, in general, investors (because we’re human) are prone to not thinking strategically enough about our portfolios. One of the causes is well know and I’ll come to that in a second. First of all, let’s look at this research…
Let’s say you had a lump sum to invest in the market to bolster your portfolio. Perhaps you’re ready and waiting to deploy the new year ISA allowance of £20,000 ! How would you do it?
Well, if you’re a typical investor, the answer is apparently that you’ll do it in a fairly naive way. That’s the finding of a team including John Gathergood at the Nottingham School of Economics and David Hirshleifer, the American economist and behavioural scientist.
They discovered that when buying multiple stocks on the same day, many investors simply divide their funds equally across the different shares and don’t think any more about it. If you were starting from scratch and equally weighting a portfolio, that would okay. But the facts are that portfolio weights change radically over time.
So whether you’re trying to keep the portfolio equally weighted or you have a range of position sizes based on your conviction, just spreading new funds equally across the portfolio is not going to be a wise strategic choice. But that’s the way we think.
Gathergood and Hirshleifer called this Naïve Buying Diversification. They found that even in experienced investors, the instinct to use very simple heuristics when making these decisions never goes away. It turns out that we’re just irrational.
The risks of narrow framing - and how to avoid it
Whether or not you’ve ever fallen for Naïve Buying Diversification, there’s a broader point here. What this research pin-pointed was another, albeit small, example of what’s known as Narrow Framing.
Narrow framing is all about making decisions without thinking about their wider impact. Like the impact a stock purchase might have in the context of a portfolio. In psychology, you can find examples of framing in all aspects of life. But in investing specifically, it can lead to all sorts of potentially costly mistakes.
For instance, randomly buying a stock because it has caught your eye or it’s been tipped somewhere, might feel harmless enough. But if your portfolio is already over-laden with similar stocks, you could become over-exposed. It might mean that you’re too heavily weighted to speculative mining stocks, or pre-profit growth plays, or small-caps or even contrarians… whatever it is, the essence of the problem is that the narrow framed decision can have hidden consequences for the portfolio.
So what’s the answer?
As Ed wrote about here, it could be about giving every stock a role that serves the rest of the portfolio. It could also mean focusing on the importance of process and having a strategy, rather than succumbing to self-attribution bias - where we like to take the credit for success and blame something else for failure. It may also means resisting the potentially costly instincts of selling winners and holding losers (the disposition effect). Here again, narrow framed decisions can have an unpredictable impact on the portfolio.
Overall, the answer is to try and take a more portfolio-based approach and think about the overall strategy. That means worrying less about individual stocks and seeing the bigger, long-term picture rather than focusing on the minutiae to the detriment of everything else.
Like Warren Buffett, it means not getting into a position where you can’t see the wood for the trees.
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I have listened to a lot of buffets writings and podcasts, the take from these is he definitely does not believe in diversification.
He states Berkshire's diversity is a result of the funds size, if he had a personal fund of 50 million dollars he would be happy to have it all invested in what he considered to be his best 3 stocks.
He and Charlie Munger have said many times diversification is a protection against ignorance.
Charlie half joking stated, having read a lot about dementia i see many similarities with modern portfolio theory
What's wrong with "very simple heuristics" when making decisions?
There's a lot of work by Gerd Gigarenzer suggesting simple rules of thumb are both rational and perform better than complicated models. Particularly, the more uncertain the environment, the more likely simple heuristics will do better than complicated models.
Obviously if you are an academic who has to publish papers, complexity is an advantage. But Harry Markowitz of portfolio theory fame admitted with his own money, doesn't use his portofolio rule, but instead uses a 1/N diversification heuristic.
Warren Buffett does hold many different shares, I think it is over 40 listed shares and quite a few others. It is not that well diversified as dawerawc says. The largest holding (Nov 2018) by far is Apple, the next largest are banks, BOA and Wells Fargo, then Coke Cola, then Kraft Heinz then there are 3 more banks. In his top 10 he has 5 banks and 2 financial companies, 1 technology and 2 food/drink companies. I can't see any insurance companies.
I think you have to be careful about applying Buffett's philosophy wholesale. While there is a lot to learn from him, BH has always been a business largely focused on American companies and therefore able to take advantage of dollar supremacy, the huge and dynamic American market and Wall Street valuations. I would suggest that for UK based investors, the biggest strategic decision to make is one that Buffett never faced: how much exposure should I have to foreign currencies? In recent research about ISA millionaires reference was made to the Aberdeen New Thai fund as being the only one that would now be worth a million if people had subscribed to it every year since ISAs were launched. But I am sure there are many far eastern funds that would run it close.
The biggest one day gain my portfolio ever had was when I didn't expect it: on Brexit day. Most of my fund holdings were up around 10%, or currency alone. It is quite possible to argue that sterling is in long term decline against both the dollar and far eastern currencies. So really, the biggest strategic question imo for UK based investors is that one: how much exposure should I have to sterling and to the UK economy. Many UK listed companies get most or even all of their earnings overseas, so it doesn't mean shunning the UK market. And if, heaven forbid, Jeremy Corbyn became PM, a portfolio exposed only to foreign companies (provided he couldn't get his hands on it) would likely appreciate dramatically as sterling fell.
I'd always understood that Berkshire Hathaway had insurance business at its heart and used the insurance premiums as investment capital, so Buffett's success was in part due to his stockpicking but also in large part due to his securing a ready source of cheap capital to invest. I've never checked that and I don't know if it is still the case but that is what I have been led to be believe by articles and commentary I've read over the years.
I agree diversification is not a defining Buffett trait. It wouldn't fit easily with his approach as a value investor which tends towards conviction purchases of undervalued sectors or business. However the hedge against ignorance quip works is only an argument against diversification if one is very confident in ones own lack of ignorance.
The thing about diversification is that it does reduce your overall returns - if you're any good at selecting shares. In fact, if you take this to its conclusion, we should only buy one share, because everything else is worsening our performance. Assuming, of course, that the one share we buy is the best performer ...
Of course, the point about this is that if you're Warren Buffett then diversification possibly does reduce your returns (although he's had his moments, too). But basically if you want to follow the advice of the best stockpicker in the world in this regard you probably need to have his talent, insight and rather unique attitude to risk. If you don't have those things then you'll generally be better off diversifying significantly, and throwing away your worst performers with alacrity.
As brucepackard above suggests, Gerd Gigerenzer's work strongly suggests that good enough heuristics beat most complex models. They're the way the brain works, so it's not that surprising that they do.
timarr
Even Buffet makes decisions that turn out to have been poor from time to time. As far as I am aware he had significant losses on his investment in Tesco and is also down significantly with Kraft Heinz. So, would he really be comfortable owning only three stocks? Perhaps it depends which three? But can one tell which in advance? One might think those companies with defensive qualities such as strong brands were safe to hold as a high percentage of the portfolio in a highly concentrated portfolio. But even a business with brands as strong as Kraft Heinz may not be a strong company if it has been starved of investment over many years.
Also, one may be absolutely correct about the strengths of a company but it is all too easy to have overlooked a weakness or there may be a weakness that is impossible to know about in advance. Some overweighting of one’s highest conviction stocks feels alright to me, but substantial overweighting feels like one has to have a “God’s eye” knowledge of the world. I know I don’t.
Great article Ben. Many thanks.
With regard to heuristics, I think it's a mistake to dismiss that aspect of investing even if it leads to some irrational decisions. Firstly irrational decisions aren't necessarily bad decisions. Secondly, a good night's sleep is more valuable than great wealth (at least it is to me). If an investor is 'comfortable' with miners and builders, say, and 'uncomfortable' with retail and airlines, it makes sense to follow one's instincts. This isn't quite as daft as it sounds, because in the long term our heuristics tend to push us away from the pain of losses and towards the rewards of gains. Deep down this is why, I believe, experience makes us better investors. This may not quite be in line with the teachings of Kahneman and Tversky but in my opinion they are too focused on rationality and disregard the importance of emotions and intuition. In fact I'd go so far as to say it's naive to believe any of us is able to be completely rational all of the time - not even Warren Buffet. So we need to factor in heuristics into our decision making - as rationally as possible.
Having delved a bit deeper, it is true Berkshire Hathaway do own several insurance companies, the problem is the reports of largest holding only show the listed companies, they own quite a few outright. Buffett like has changed his strategy over the years, if you read some of the older articles and what he said about technology and airlines you may surprised to see what he holds now, Apple is his largest listed holding by some way. Yes he has made quite a few mistakes recently, Tesco (LON:TSCO) was one, GE was another and Kraft Heinz also. His best performing shares in the last year or so have been Verisign, Mastercard and Visa but this seem relatively small holdings, Moody's is his best larger holding. He is diversified but over overweight is several sectors such as technology and financials.
One of the reasons the Aberdeen New Thai trust has done so well over the life of ISAs is because the start point was in the aftermath of the 1998 Asian financial crises. It think the Thai market lost approximately 90% of it's value and has only recently got back to that level. Combine a good entry point, healthy economic growth and good fund management and the result is very good.
Trusts like Aberdeen Standard Asia Focus & Scottish Oriental Smaller Companies have done almost as well, for similar reasons. I have held both for 10 years & had a different Asian trust before that.
I don't see any markets presenting such an attractive entry point now, as the likes of Turkey and Argentina have not fallen by anywhere near as much & governance seems worse. Argentina is a serial defaulter and Turkey is run by someone with no grasp of economics.
Portfolio strategy is an interesting topic. Last summer, I reduced the percentage of stocks and trusts back to about 79~80% & would probably only move back to near 100% if I could find outstanding opportunities. Mohnish Pabrai made a very interesting comment, saying he would only go to 100% invested if the last 10% of his capital was expected to make about 40% a year. That's one way of keeping something in reserve for a downturn.
I do worry slightly about my preference for Investment Trusts above Unit Trusts, since if we have a Marxist government, the discount might widen as people sell up and emigrate with their money.
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Thanks Ben
I already determine my conviction rating at the end of my share selection process. So, as a result of your piece, I will now base my investment size upon it.