Focus investing is generally defined as maintaining a portfolio of 10 stocks or less. This strategy contrasts with the much more commonly used strategy of diversification, where investors typically own as many companies as they like and have cash around to spend. There are plenty of reasons to invest in only a few companies at a time. In fact, some of the most successful investment strategists and intelligent people ever have advised us to do so:
Warren Buffett: "If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you."
"Do not place small amounts in each basket. Only buy if you are prepared to put at least 10% of your net worth into the stock."
Mark Twain: "Put all your eggs in one basket - and watch that basket."
Peter Lynch: "There's no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors."
When Warren Buffett, Mark Twain, and Peter Lynch say something, it might be worth considering. I personally invest completely in one company at a time but I recognize that this extreme form of focus investing requires very high volatility tolerance that most investors don't possess. However, I believe 10 carefully chosen stocks is plenty for even the most price sensitive investors. So why should you listen to me?
The responsible investor follows each and every one of his holdings. It takes a constant amount of time per week to stay up on a company. I would advise at least an hour per week. Again this time is constant, whether that company makes up 2% of your portfolio or 100%. The business world does not slow down for you just because you have more companies to follow and more things to read every week. You cannot enhance your brain's ability to take in information you read by diversifying into more companies. If you diversify and own more and more different companies but continue to devote the same amount of time every week to research, then you are dividing your time by an increasing denominator, such that you will spend less and less time following each individual company you own. Not staying up on a holding is a recipe for disaster. Imagine if shareholders of Apple (NASDAQ:AAPL) hadn't followed the company since late September until this morning. They would have woken up to a 35% loss. Be honest with yourself; do you devote as much time to staying up on your investments as you should?
Now of course, the investor can own more than one stock without being handicapped, so long as he is willing to spend more and more time following each additional company. He could own 10 companies and still diligently follow them, but he'd have to devote ten hours instead of one. But wait, if he was willing to devote 10 hours total to stock market research when he held 10 companies, why not spend the same time researching, but while only holding one company? He could spend 5 hours per week keeping up on Apple and another 5 researching potential investments, comparing them against Apple, only considering them if they seemed much more attractive. Or consider this, he could spend the original hour keeping up on Apple, and work 9 more hours per week at his day job or writing articles for Seeking Alpha, adding the extra income to his savings. There are many possibilities, but once you think of time as a finite resource and holdings as needing a constant amount of research time, you will see the attractiveness of a portfolio of as few companies as possible.
Like time, great ideas are also a limited resource. They are hard to come by, and so you should capitalize when you do find one. I don't care if you're Peter Lynch, everyone has one idea they like most. Even the most trained, talented stock pickers, capable of identifying hundreds of attractively priced companies per year, have one in particular that they like most. If you have any confidence in your ideas whatsoever, this is the idea you are most confident in or expect to appreciate the most. So why settle for anything less? If what you're expecting happens, you'd make the highest return by allocating all your money into this one idea. Personally, I cannot stand to put money in a company when I know there is a better alternative.
Comparing ideas will also save you countless hours of, guess what, time. When we measure investment ideas in terms of opportunity costs, the next best alternative (our current holding), then it becomes much easier to dismiss prospects, even if they are somewhat good ideas, as long as they don't measure up to what you already have in front of you. By doing this, we can constantly improve the quality of our holding(s) until there are no better ideas out there to replace our existing holdings. The process takes much less time and research than you'd think, because we are only taking an in depth look at the companies that seem better than the ones we currently own.
Why do most investors diversify. The answer is because they intend to reduce what they think is risk. The truth is that diversification does reduce something, but not risk. Diversification reduces volatility, or the degree to which prices fluctuate. Far too often investors confuse volatility for risk. Consider this example which illustrates the difference. In baseball, teams pay a high price for star players. The risk when they purchase these players is that they will underperform. We will define their performance by their batting average. A player that goes through hitting streaks and slumps could be said to be a volatile player, but if his streaks outweighed his slumps and his season batting average was still high, the team would be pleased. If however he slumped the entire year, his average would not be volatile at all, but his season average would be much lower than the team had expected. They'd be disappointed and have wasted their money. Signing a baseball player is an investment just like purchasing a stock. Fluctuations mean nothing in the end; what matters is cumulative performance at the time of selling. Risk is defined as the chances of this performance being materially less than expected. Thus, the main logical reasoning for diversification is flawed.
Regression Towards the Mean
I'm not one for statistical analysis(that's where useless volatility values like beta come from), but I think this argument might really appeal to statistically driven investors. Regression to the mean is a tenet of statistical analysis. It is the idea that given an event with multiple outcomes, the more trials (or stocks) there are, the closer the results will get to the average. Think of a coin flip. You may flip heads 10 times in a row, but if you flip 300,000 times you can bet it'll be heads close to 50% of the time. The more you flip, the closer the results get to the average. The same is true of investing. The average return of the S&P 500, the benchmark or average that most investors compare their returns to, is about 9.62%. The more companies you own, the closer your results will get to this average return. If you are happy with average, then diversify all you want, but why even waste your effort then when you could just invest in a S&P 500 index fund and always match its performance with no personal effort. Investors who do their own investing desire higher than average returns or they'd be in an index fund. If you seek a return that is much higher than average, then why diversify and increase your statistical likelihood of average returns?
In economics there is a term called "elasticity." It is how quantity demanded(or supplied) changes with price. The more elastic the demand, the more consumers care about the price they are paying and the value they are getting for that price. One factor that influences elasticity is price itself: the larger the percentage of a consumer's net worth the product costs, the higher elasticity is. The more of a consumer's net worth is on the table, the more concerned they are. I believe this principle translates into investing as well. Stocks kind of are a product in a way, or at least we treat them as such. The more money an investor has riding on an investment or potential investment, the more important it will be to the investor. If it is very important to him than he will do more research and make more informed, accurate, decisions, whereas if he makes a bunch of small transactions, his demand is more inelastic and he is more likely to throw money around and make bad decisions. It is a phenomenon that can only be explained in human nature and how we think, but nonetheless is true and good reason to focus invest and keep your investments important to you.
Advantage of Retail Investor
Ask any professional money manager, they will all say that individual retail investors with relatively small portfolios have huge advantages over 'smart money' fund managers. The reason is that we are dealing with less money, so we are able to spend all our time researching a single small or mid cap and only investing in one. The large fund manager has too much money to feasibly make one investment and small and mid caps aren't even really worth his time. He must find many good ideas. Fund managers are also often restricted from investing in one company. Typically they are not allowed to hold more than 5% of total fund assets in one stock. The reason is because funds have good reasons to diversify- clients could ask for their money back at any time and so the company needs to limit volatility to ensure they are always capable of fulfilling all redemptions without further affecting performance by having to sell stock that is undervalued. Individual investors don't have to worry about 'refunds' as long we are only investing money we can afford to lose. By only needing to find one great idea to capitalize on, we have a huge advantage.
Transaction costs and capital gains taxes can be quite expensive, but only if we buy or sell stock. As long as you hold a stock you are not subject to these expenses. The transaction costs are also per investment, not per share. So say my broker's transaction fee is $10 per trade. If I split my money between 30 companies, I pay $300 in transaction costs, but if I put all my money in 1 company, I only pay $10.
We are also likely to hold stock longer when we only own 1 stock. By holding stock longer, we minimize capital gains taxes and further save money.
I have gone through every logical reason I can think of for focus investing. I practice this right now. I only own stock in Apple and I feel like I know so much about the company. I also have so much more time to myself and am under much less pressure compared to when I owned stock in 6 companies. I can hardly imagine how bad it would be with 30 holdings. There are plenty of price fluctuations when you only own one stock, but if you can keep yourself rational and ignore market noise, you will be okay. It helps to remember that every time you sell, you face capital gains and transaction costs. I recognize that no matter what my reasoning, focus investing won't be for everyone simply because some people have such low tolerance for volatility. My goal is not to convert the world, I simply want to make a case for focus investing for you to consider.
Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.