The Delicate Art Of Balancing Diversification And Concentration

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Includes: AAPL, AXP, BAC, BRK.A, BRK.B, KO, VT, VTSAX, WFC
by: App Economy Insights
Summary

Most investors are well versed with the importance of diversification and building their portfolios on the efficient frontier.

Yet, they need to reconcile with the fact that some of the greatest investors of all time such as Buffett, Munger, Icahn or Soros make huge concentrated bets.

Diversification needs to be sufficient, but not excessive.

A possible solution is the concept of being "passively active," an idea brought by Robert G. Kirby with his Coffee Can portfolio.

Abnormal returns require abnormal portfolios - and concentration is the path to generate alpha, as long as you know what you're doing.

One of the first rules you learn in investing is that you can reduce some of the risks and volatility of your portfolio thanks to diversification.

Investing in multiple uncorrelated assets is a powerful way to limit portfolio draw-downs in any given year, without necessarily compromising your potential returns.

In a world now dominated by passive investing via ETFs (exchange-traded funds) and robo-advisors automatically rebalancing your asset allocation, investors have many affordable options to diversify and make sure they keep up with the market.

Yet, if your goal is to focus on capital appreciation and generating alpha over the very long term, making concentrated bets is almost a requirement.

Risk-averse investors, including professional portfolio managers, think they are taking too much company risk as soon as a stock reaches 3% of their net worth. Yet, many are willing to take a 30-year mortgage to buy a single family home with a down payment that represents the vast majority of their assets.

The explanation is simple. Making a concentrated investment requires appropriate due diligence and usually involves a predefined goal and time horizon. If you know what you are buying and understand clearly the upside opportunity and downside risk, making a concentrated investment isn't necessarily reckless.

Here again, the due diligence that comes with buying a house is a perfect analogy. Home buyers can afford to make a concentrated investment because they do the hard work ahead of time:

  • Define how long you intend to stay (time horizon and goal setting)
  • Study the marketplace (benchmark)
  • Visit the property (analysis)
  • Hire an inspector (paid research)
  • Get an appraisal (valuation)
  • Schedule an environmental assessment (fact based quality factors)

How concentrated your portfolio can be ultimately depends on what you put in the portfolio. If you behave like a business-owner (or a home buyer), focusing on high quality companies that are likely to deliver outstanding returns on invested capital over the years, there is nothing wrong with focusing only on a handful of ideas.

Abnormal returns, after all, can only come from abnormal portfolios. If you need some form of concentration to deliver significant alpha, it all boils down to the intrinsic quality of the individual investments you put in the portfolio. The higher the quality of the individual bets, the more concentrated you can be.

I explain below why investing in its purest form - like a business owner - is the key to allow portfolio concentration and generate alpha.

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An introduction to being passively active

Let's get something out of the way.

Low-cost index funds are an amazing way to invest and a perfectly fine solution for the vast majority of the population. For those not having the time or the temperament to seek alpha, it is the right way to invest. ETFs that match the entire stock market performance with extremely low fees such as Vanguard Total Stock Market Index (VTSAX) in the US or the Vanguard Total World Stock ETF (VT) are particularly popular in communities focused on financial independence. I'm personally invested in equities via low-cost ETFs in the majority of my tax advantaged accounts and I'm very thankful for the simplicity and performance they can deliver over a lifetime.

Being actively passive is, for the most part, what robo-advisors like Wealthfront, Betterment and most 401K providers offer in the US. They consist of portfolios spread into a wide range of asset classes and ETFs based on a predefined risk tolerance and time horizon. This strategy uses passive tools like index funds or ETFs, while managing them actively with the use of common approaches such as rebalancing and tax-loss harvesting. Being actively passive is a strategy that focuses on avoiding market underperformance. To do so, it practices outrageous diversification by holding essentially the entire stock market. It is, intrinsically, the opposite of seeking alpha. It's no surprise to see those behind the Efficient Market Theory like Burton Malkiel wholeheartedly supporting this approach to investing.

Wall Street is filled with market analysts predicting how a company will perform over the next quarter, and they still get it wrong. It's easy to see how they are necessarily wrong over an extended time. The market, as a result, can only be as efficient as the sum of its knowledge at any given time.

Now, I want to bring again the idea of the Coffee Can portfolio from Robert G. Kirby, who introduced in 1984 an idea that really resonated with me:

You can make more money being passively active than actively passive.

Being passively active is an extreme version of the good old "buy and hold" approach.

  • The active part is your buying strategy - your investment selection.
  • The passive part is your behavior - that is, not to sell at all, for as long as you possibly can. Sitting on your hands if you will.

Robert G. Kirby uses the image of a Coffee Can to illustrate the passively active approach. He explains:

The Coffee Can portfolio concept harkens back to the Old West, when people put their valuable possessions in a coffee can and kept it under-the mattress. That coffee can involved no transaction costs, administrative costs, or any other costs. The success of the program depended entirely on the wisdom and foresight used to select the objects to be placed in the coffee can to begin with.

This strategy is built to derive alpha over the long term. It does so by eradicating all fees, and by specifically not trying to match the market performance in the short term. Assets are picked for their inherent quality and left alone over an extended period, without the disruption of any transaction costs.

The Coffee Can portfolio is, to a large extent, part of Warren Buffett's strategy. He likes to say that his favorite holding period is "forever." This approach has generally implied high concentrated bets. It certainly worked out well for him. As of end of March 2019, Buffett had 65% of his equity portfolio at Berkshire Hathaway (BRK.A) (BRK.B) in his five biggest holdings:

  • Apple (AAPL) 24%
  • Bank of America (BAC) 13%
  • The Coca-Cola Co (KO) 10%
  • Wells Fargo (WFC) 9%
  • American Express (AXP) 9%

While recognizing the benefits of being actively passive (maintain an allocation that matches the market performance while limiting draw-downs), it makes perfect sense that one of the ways to generate tremendous alpha over a lifetime is to embrace the opposite approach.

Robert G. Kirby illustrates the positive results of this strategy with the portfolio of a client he had worked with for over a decade. The client had invested around $5,000 in his wife's portfolio for each of Kirby's purchase recommendation, without ever selling. The result, after decades, was a portfolio with several small positions around $2,000, a few large ones that had grown to $100,000 and one that had returned over $800,000.

Over an extended time, a portfolio that isn't rebalanced is going to get heavily concentrated. If you are successful with this strategy, you will end up with an odd-looking portfolio with a few winners generating most the alpha. Kirby's friend would have never generated such returns if he had re-examined and rebalanced his portfolio regularly as taught in most modern corporate finance classes.

If your portfolio ends up highly concentrated over time, it will have necessarily been fueled by a selection of alpha generating investments. In a way, your allocation is only putting at risk money you wouldn't have had to begin with if you had followed a market index.

After all, your portfolio is not supposed to look like the S&P 500 if you want to beat it. The shape of your portfolio should be the result of its performance. By embracing a Coffee Can approach, a single investment is very likely to return more than all your investments combined. It might sound like a romantic idea at first, but it's the natural result of the world we live in. A world governed by the power law.

The Coffee Can approach can solve the grand dilemma of balancing diversification and concentration:

  • Diversification is driven by an initial asset allocation satisfactory to the investor's goals and time horizon. A maximum initial allocation to a given investment entering the coffee can can be defined as a safeguard.
  • Concentration is a result of many years of performance of the aforementioned assets, without the portfolio being re-examined or re-evaluated. In all likelihood, without any rebalancing compromising the winners, the best performers will be taking a larger part of the portfolio over time, giving it a top-heavy allocation similar to the power law or Pareto, with 20% of the investments driving 80% of the returns or more.

An important aspect of the passively active approach is that you only need to be right once. There is no market timing, no buyer's remorse when a stock is down 50%. You make an investment decision and simply let it work over several years.

Now that we've established what passively active is, let's review why it might be a superior solution.

The problem with over-diversification

Modern Portfolio Theory has created a wide range of solutions for investors to maximize their returns based on the risks they are taking. Most investors are well versed with the idea that they need to build their portfolio on the efficient frontier.

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But a key issue here is that the efficient frontier doesn't necessarily tell you if your portfolio is over-diversified - and therefore unlikely to generate alpha.

In his book Principles, Ray Dalio explains that all you need to monitor your downside risk is 15 uncorrelated assets:

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That simple chart struck me with the same force I imagine Einstein must have felt when he discovered E=MC2: I saw that with fifteen to twenty good, uncorrelated return streams, I could dramatically reduce my risks without reducing my expected returns. It was so simple but it would be such a breakthrough if the theory worked as well in practice as it did on paper. I called it the “Holy Grail of Investing” because it showed the path to making a fortune. This was another key moment in our education.

Back testing as far as possible, the results will mostly tell you the same things again and again. Stocks deliver the highest return over an extended period. And stocks will suffer more significant draw-downs when they have a bad year.

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If your goal is capital preservation and low volatility, a diversified "all-weather" portfolio may make perfect sense. But it will also prevent you from matching stocks performance over the long term or generating alpha altogether.

The problem with rebalancing

Rebalancing is a common practice in the investment counsel business. It's meant to diminish the potential of black swan events that can impair the standard of living of an investor. Essentially, rebalancing is the act of selling assets that have recently overperformed to buy assets that have recently underperfomed in order to maintain a constant asset allocation and level of portfolio risk.

Typically, portfolio managers would sell the shares of dynamic companies that are considered overvalued to raise cash to buy shares of companies that are less dynamic and considered undervalued.

In the context of a portfolio built for capital appreciation with a very long time horizon, rebalancing makes very little sense. In fact, for investors having decades ahead of them before any withdrawal, rebalancing is a weapon of alpha destruction.

Sure, rebalancing is limiting the potential of a surprising downside. But, in the process, it's also guaranteeing the absence of a fantastic upside. Any investment that provides tremendous returns in the short term will be shut down before it can grow to a meaningful portion of a portfolio.

Rebalancing is the act of neutralizing risks and opportunities. A way to actively take from the most dynamic part of your portfolio and re-allocate to the least dynamic part of your portfolio. At its core, it prevents any successful piece of a portfolio to compound to what would truly be a life-changing performance.

While a powerful tool to manage portfolio risk, rebalancing diminishes your opportunity to the exact same extent.

Diversification needs depend on what's in the portfolio

You can find a gold mine of information in the archives of Berkshire Hathaway annual meetings. Every year, two of the wealthiest people on earth - Warren Buffett and Charlie Munger - sit down with shareholders in Omaha and share their wisdom.

As I was researching answers to the optimal number of positions that should be in an equity portfolio, one of the subscribers of the App Economy Portfolio shared with the community the archives from the 1996 annual meeting. Responding to a question about the appropriate size of a new investment, Warren Buffett explained:

We like to put a lot of money in things that we feel strongly about. And that gets back to the diversification question.

You know, we think diversification is — as practiced generally — makes very little sense for anyone that knows what they’re doing.

Diversification is a protection against ignorance.

I mean, if you want to make sure — (laughter) — that nothing bad happens to you relative to the market, you own everything. There’s nothing wrong with that. I mean, that is a perfectly sound approach for somebody who does not feel they know how to analyze businesses.

If you know how to analyze businesses and value businesses, it’s crazy to own 50 stocks or 40 stocks or 30 stocks, probably, because there aren’t that many wonderful businesses that are understandable to a single human being, in all likelihood.

And to have some super-wonderful business and then put money in number 30 or 35 on your list of attractiveness and forego putting more money into number one, just strikes Charlie and me as madness.

And it’s conventional practice, and it may — you know, if you all you have to achieve is average, it may preserve your job. But it’s a confession, in our view, that you don’t really understand the businesses that you own.

Charlie Munger to add:

Yeah, what he’s saying is that much of what is taught in modern corporate finance courses is twaddle. (Laugther and applause)

I've been very humbled by this segment of the annual meeting because it made me look at the bottom of my portfolio with criticism. I have a natural tendency to be excited about the prospects of new businesses and feel more inclined to start positions in new ideas rather than adding to my existing positions.

Chances are, your best ideas are already at the very top of your portfolio. Most of the time, your biggest holdings are where new funds should be allocated when the story and opportunity is intact, the same way Buffett and Munger have added diligently to Coca-Cola (KO) for years.

The main factor in determining your allocation should be the nature of the investment opportunity you are looking at. A small biotech that has less than 50% chance of receiving an FDA approval should not represent a significant part of your portfolio. Similarly, there isn't much risk to having a 24% allocation to a company like Apple (AAPL) at a valuation of 16 times earnings.

Your portfolio allocation should be a reflection of your degree of knowledge and certitude. The size of an investment should be proportional to your probability of success.

An educated investment should be similar to a game of Texas Hold'em poker where you would be able to see everyone's cards and make your decision accordingly before seeing the flop, the turn and the river unfold. You have to recognize when you have a good hand with odds in your favor.

Why you need to leave your winners alone

One of the most powerful charts I came across in recent years is the research done by Blackstar Funds, via Meb Faber. The charts shows the historical distribution of 8,000 stocks trading on the NYSE, AMEX and NASDAQ over decades (1983-2006).

Over this multi decade period, 25% of the stocks were responsible for all of the gains.

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The takeaways are fascinating:

  • 2 out of every 5 stocks are money losing investments (39%).

  • Nearly 1 out of every 5 stocks is a terrible investment (losing 75% or more).

Looking specifically at how individual stocks returns compared to the Russell 3000 index, other conclusions emerge.

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  • Most stocks can’t keep up with a diversified index (64% under-performed the Russell 3000 during their lifetime).
  • Only 6% of stocks significantly outperformed the index (500% or more).

Now, let's assume that your portfolio has a mix of investments spread evenly on the returns distribution charts above. The winners, the very companies that drive the market indexes higher and can generate alpha for your portfolio, will tend to have the same behavior. They keep on reaching new all-time-highs and slowly overtake your portfolio allocation.

With only about 1 out of 16 stocks dramatically outperforming the index, it becomes clear that these are the most precious assets of your portfolio.

Now, the very nature of rebalancing would force you to sell some of the assets that are on their way to enable your portfolio to deliver strong performance, only to re-allocate the funds to new positions that only have a 6.1% chance to be dramatic out-performers.

My personal conclusions out of this research is what is driving a core aspect of my investing philosophy:

  1. Alpha is driven by a very small amount of outstanding performers.
  2. Don't sell your winners. Instead add to them over time.
  3. Accept that you'll have losers. Statistically around 40% of your picks.

This core idea that you let your portfolio concentrate for you through its sheer performance is one that I've covered previously. It most resembles the way VCs invest in individual companies. They have a diversified approach with investment in many start-ups. But their performance is driven by the few of them that turn into unicorns or decacorns.

Here again, opting for a behavior that most resembles the one of a true business owner with a multi-decade time horizon goes a long way.

Conclusion

Financial literature is overwhelmingly clear that you shouldn't try to beat the indexes with an individual stock selection. If you are spending a very limited amount of time looking into investment opportunities and simply want to match the average performance the market is willing to give you, diversification should be your priority. And you are in luck with more affordable options than ever before.

Yet, over the very long term, a dedicated research focused on quality can lead you to find outstanding investment opportunities. This applies to private equities, real estate, art or any other form of appreciating asset. Why would it be so different for public equities?

An entire industry of financial professionals tell you that you can't do it. Warren Buffet and Charlie Munger disagree.

The real key becomes temperament and execution. Being passively active, by letting your investments tell their story over decades, can lead to higher returns than the market. The question is, will you let them?

Disclosure: I am/we are long AAPL BAC. 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.