Focus investing... when is owning less stocks more?

Decades of academic research has found that diversification can slash the risk of portfolio wipeouts. But there is also evidence to suggest that diversification is overrated and encourages investors to aim for ‘average’ returns. Warren Buffett described it as “protection against ignorance”, and other famous investors like Joel Greenblatt, William O’Neill and Gerald Loeb tend to agree. Instead, these stock market hunters confidently place big bets on a smaller number of stocks by relying on strict rules and detailed company knowledge. So who should use this approach?

Academics and investors disagree

Before looking closer at focus investors, it’s worth noting why academics and some investing professionals have fallen out over the issue of diversification.  

Back in in the early 1950s American economist Harry Markowitz figured out a way of creating an optimal share portfolio. Rather than just buying popular stocks, which was common at the time, Markowitz examined the relationship between risk and expected returns. His model - which he called the efficient frontier - found that it was important to diversify across uncorrelated assets. This tied-in nicely (and in many ways relied on) a theory that emerged later on called the efficient market hypothesis.

Markowitz’s work was the basis of what’s now known as modern portfolio theory and it earned him a Nobel Prize for Economics. But others had their doubts. The theories were criticised for making the erroneous assumptions that markets are perfectly efficient and that investors behave rationally.

Indeed, Buffett has been a vociferous critic. He once said: “I’d be a bum on the street with a tin cup if the markets were always efficient.” In his 1993 letter to Berkshire Hathaway shareholders he rejected ‘diversification dogma’ and insisted that portfolio concentration may well decrease risk if it makes an investor think harder about a business before buying into it.

Super investors use concentration

Buffett isn’t alone with this opinion. Some of the world’s best known investors have made fortunes from concentrated portfolios of stocks they understand well. Among them is US fund manager Joel Greenblatt, who wrote The Little Book That Beats the Market. He says that short-term thinking and overly complicated statistics can make it feel safer to own many companies that you know very little about rather than owning stakes in five to eight companies that have good businesses, predictable futures and bargain prices. He notes:

“For the few who have the ability, knowledge, and time to predict normal earnings and evaluate individual stocks, owning less can actually be more - more profits, more safety… and more fun!”

Popular growth stock investor William O’Neill sees things the same way. In his book How to Make Money in Stocks, he argues that jacks-of-all-trades and masters of none are rarely dramatically successful in any field, including investing. He says that the best results are usually achieved through concentration, and that investors should put their eggs in a few baskets they know well and watch very carefully.

The case for concentrated portfolios even has some academic backing. A 2006 US study compared the performances of concentrated and diversified portfolios held by US households at a discount brokerage. It found that among the largest portfolios (in terms of value), the holdings and trades of those focusing on a few stocks tended to perform much better than those that were diversified across many stocks. It concluded that wealthy households who concentrate their holdings just tend to be better at picking superior stocks.

How to be a focus investor

To understand what it takes to be a focus investor, one need look no further than Buffett. Famous for blending value and quality factors in his investment process, Buffett likes to make big, high-probability bets over the long-term. In a book called The Essential Buffett, Robert Hagstrom of asset manager Legg Mason Investment Counsel, suggests some golden rules for focus investors based on what Buffett does:

1. Concentrate your investments in outstanding companies run by strong management.
2. Limit yourself to the number of companies you can truly understand. Ten is a good number; more than 20 is asking for trouble.
3. Pick the very best of your good companies and put the bulk of your investment there.
4. Think long-term - 5 to 10 years minimum.
5. Volatility happens. Carry on.

As a final note on all this it’s worth just having a closer look at point 3 (above). How do focus investors decide how much capital to deploy in one stock? Arguably this is where the key difference lies between investors who value diversification and those who don’t. The answer is that it naturally comes down to personal preference... but for maths geeks there is a way to work it out.

Place your bets with the Kelly formula

Buffett bets big when he calculates that the probability of excess returns is high and the odds are in his favour. Focus investors can do the same thing by using a tool called the Kelly Optimization Model. Developed by a mathematician called J.L. Kelly, it’s a way of using probability to work out what proportion of your funds should be in a stock (or on a bet) to maximise growth over the long-term. The formula looks like this:

Your stake = 2p - 1

In other words, 2 times the probability of success minus 1 equals the percentage of your portfolio that should be allocated. On that basis, if you think the probability of success is 75% then you should deploy 50%. That sounds scary because this is a very aggressive way of ruthlessly chasing growth. As a result it can wipe you out. Even proponents of the formula suggest reducing the exposure or using a half-Kelly as an alternative.   

Balancing focus and diversification

While academic evidence suggests that diversification does reduce portfolio risk, not everyone agrees that it always makes sense. For stock market farmers who use rule-based strategies to build portfolios that harvest the market premium, diversification can reduce risk - as Ed has written about here. But for stock-picking hunters who bet big on high conviction, high probability stocks, diversification is less compelling. Even so, it’s worth remembering Greenblatt’s warnings that: “Most people have no business investing in individual stocks on their own!”... and ask yourself: do you have the skills and discipline to invest like Buffett?