Diversification And Outperformance: The Biggest Lie In The Investment Business

by: Loic LeMener, CFA

Good investment ideas are hard to come by. The best way to develop a great idea is to have an informational edge.

Concentrated investors scour the market for the rare company that they understand and can offer a wonderful risk/return tradeoff.

Most portfolio managers can find some good ideas and do tend to put more of their money behind those best ideas; however, “institutional factors” push them to over-diversify.

The hard part of this strategy is sticking with a portfolio manager who is underperforming. Investors need to do their homework and have a conviction in their manager that goes beyond recent performance numbers.

SUMMARY: The idea that "diversification is the only free lunch" is, in a sense, the biggest lie in the investment industry. Some investment managers pitch a diversified portfolio that eliminates single stock risk while simultaneously delivering outperformance. But the notion that a manager can consistently beat their index while also guaranteeing no individual holding can depress the overall portfolio is simply impossible. Investors need to understand the differences in diversification and concentration investment strategies and their benefits and drawbacks.

"The idea of excessive diversification is madness" - Charlie Munger

The famous investment saying that "diversification is the only free lunch" might, in a sense, be the biggest lie in the investment industry. There are no free lunches; beware of anyone who offers you one. When it comes to investing, some managers (particularly mutual fund managers) pitch a diversified portfolio that eliminates single stock risk while simultaneously delivering outperformance. But such a portfolio rarely fulfills its promise.

There are so many conflicting opinions in the investment business, it's tough to separate the signal from the noise. I've developed a three-part model for myself that my highest conviction ideas seem to follow:

  1. It's a rational idea (i.e., it makes logical sense). When Charlie Munger was asked why he and Buffett have been so successful, he responded, "We're rational." While that may be an obviously desired trait, many people let biases and emotion affect their opinions. If you can truly think through why 1 + 2 = 3, you might be onto something.
  2. It's seconded by other investors. There are many brilliant investors out there. I look for strategies that have been used by several of the most successful investors in history.
  3. It aligns with academic evidence that supports the idea.

If all three of these items are in agreement, you can feel fairly confident that you have something with the potential to be successful.

The Logic of a Concentrated Portfolio

If financial markets are mostly "efficient," as many academics claim, opportunities to outperform should be hard to find. A "great" idea in the world of investing is akin to a miner finding gold; it's infrequent and takes skilled and relentless pursuit. The best way to develop a great idea is to have an informational edge, meaning you know more about a company (in the case of a stock) then the people selling the stock to you. In this case, your competitors have stepped over a nugget of gold without realizing it. Given limits on people's time, memory, and intellect, no single person can come up with an abundant amount of great ideas at any one time.

Put yourself in the shoes of a fund manager. You are paid millions (if not tens of millions) of dollars to beat the market. You log hundreds of hours of analysis to get to know your best ideas and have conviction in them…and then you're going to turn around and put 2% of your fund into your best idea? That means the manager is putting 98% of the fund in less-than-best ideas.

This point is so simple that it's almost embarrassing to bring up. If you have fund manager A who spreads his capital across 30 stocks and fund manager B who spreads his capital across 100 stocks, fund manager B is challenged to come up with more than three times the number of good ideas as fund manager A. If you believe that high conviction ideas are rare, this is a very tall task. It's also extremely unlikely that fund manager B's 97th best idea is anywhere close to fund manager A's 25th best idea.

In short, if you want your portfolio manager to outperform while also finding you a lot great ideas such that you can be very diversified, you're just asking for too much.

What the "Greats" Say About a Concentrated Portfolio

Many great investors over the decades have used a concentrated approach to outperform. Rather than casting a wide net and investing in a large number of companies about which they have only average knowledge, concentrated investors scour the market for the rare company that they understand and can offer a wonderful risk/return tradeoff. Concentrated investors may only find one or two of these prime investments per year, and when they do, they bet big.

Bill Nygren of Oakmark pointed out in 2014 that the average stock mutual fund holds 121 stocks. Wow - do some people really think they can have a competitive edge on 121 stocks? Recalling a panel discussion in which a manager proposed heavy diversification as a guarantee against any single mistake hurting the portfolio, Nygren wrote, "My response was not well-received: 'If mistakes don't matter, doesn't that mean successes don't matter either?' They are 'closet indexing' with the goal of not underperforming by enough to get fired."

Compare this to the philosophy of one of the best portfolio managers in the business, Allan Mecham, who typically has most of his portfolio in his top 10 ideas. He said, "We buy stocks the way we buy toilet paper: high quality, on sale, and in bulk sizes." When he says in bulk size, he means it. Allan often has more than 20% of his portfolio in his best ideas. In a sense, he's setting a low bar for himself. He has said, "If I find two new ideas a year, that's phenomenal." Find two phenomenal ideas a year, keep them on average for 5 years so you have a 10-stock-or-so portfolio over time and set yourself up for success.

This "two ideas a year" resonates with the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) model as well. Charlie Munger explains: "If you look at Berkshire and you take out 100 decisions, which is 2 a year, the success of Berkshire came from two decisions a year over 50 years…we may have beaten the indexes but we didn't do it having big portfolios of securities."

Warren Buffett seeks out this philosophy when he's looking for portfolio managers as well. Speaking about his lieutenants Todd and Ted (who together manage billions of Berkshire's money and at the time held only 14 stocks between the two of them), Buffett stated, "They're smart, so they put their capital behind their best ideas. I wouldn't care if they held a lot less."

While two a year may be extreme (hence Berkshire's and Mecham's extremely good results), it is reasonable to assume that an individual trying to find 50 good ideas a year is at an extreme disadvantage.

The Academic Evidence

Many academic studies support the notion of concentrated investing:

  • A Harvard study from 1991 to 2005 of U.S. Equity manager's "best ideas" beat their index by 7% annually.1
  • A 2003-2013 analysis of large and mid-cap U.S. managers holding fewer than 35 stocks outperformed their benchmark by 2.44%.2
  • Focused managers outperform their more broadly diversified counterparts by approximately 30 basis points per month or roughly 4% annualized.3

Harvard and MIT professor Randy Cohen sums up these findings by writing: "The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over-diversify."

What Cohen is saying is that most portfolio managers can find some good ideas and do tend to put more of their money behind those best ideas; however, due to "institutional factors" (meaning not being willing to concentrate so as to never underperform too much), they over-diversify and their non-best ideas weigh the portfolio down so much it ends up underperforming as a whole.

If It's So Obvious, Why Don't More People Do It?

The main issue that keeps concentrated investing from being more popular among managers is what's called "benchmark risk." This is the risk of underperforming your benchmark in any given year. The more different you look from your benchmark, the higher the chance you'll deviate from it, and eventually, you're going to deviate in the wrong direction (i.e., underperform). Clients can tolerate many years of mediocre performance, but if you underperform significantly, even over a short period, a lot of your investors are going to get scared and run.

Given the dynamic above, if you're worried about a client firing you, you have to balance the risk of being wrong on a meaningful position versus the certainty of having most of your portfolio in your non-best ideas. I believe the industry routinely overweighs the latter.

Some people think concentrated investing is arrogant. But which is more arrogant? Thinking you can come up with 60 great ideas or thinking you can come up with a few a year? Of course, a mistake on a concentrated position is extremely visible, whereas with a diversified portfolio it's more akin to "death by a thousand cuts." This differentiation of optics matters a lot in the investment business.

Realities of Implementing

The hard part of this strategy is sticking with a portfolio manager who is underperforming (but then again, isn't that the hard part of any strategy?). If you're going to use concentrated managers, you must do your homework and have conviction in them that goes beyond recent performance numbers. You have to understand the "why" of what they're doing and qualitatively assess the fund's strategy during the inescapable "performance winters."

Alternatively, let's say you agree with the logic of concentrated investing but know you can't emotionally handle having all your money in concentrated strategies. No problem. You could index 80% of your stocks and then have 20% of your funds in a concentrated strategy. That way, you're paying a lot lower fees than a closet indexer, and in my opinion, have a higher chance of success.

You can also buy as many high-conviction managers as you want; however, the rarity of "great managers" follows the same logic as finding a great stock. You're likely to only find a few managers in whom you have high conviction at any one time.

For me, an ideal equity portfolio looks like this: finding roughly five managers who all put their money in their top 10 ideas. That way you have a moderately concentrated 50-stock portfolio with five different teams trying to come up with two to three good ideas a year. This is admittedly extremely hard to find but striving for something close to it is worthwhile.

For those willing to do their homework, in this era of very expensive indexes, this is a methodology worth considering.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.