The Pitfalls of Excessive Diversification and Excessive Concentration
For my stock picking portfolio, I strive to maintain a portfolio comprising approximately 15 companies possessing strong moats across diverse industries. I’ve concluded that this (12-15 stocks) is the optimal portfolio size. This is informed by what I’ve learned from the research and my own backtesting research, which I wrote about in a previous article.
However, my thinking on this isn’t only derived from backtests. It is also informed by practical experience and observation.
From a practical standpoint, managing a portfolio becomes challenging when it grows too large, making it difficult to stay abreast of developments and effectively monitor each position.
Keeping up with every K and Q, every earnings call, and every development for 30 stocks is an extremely difficult task for a part-time investor such as myself. I did this for years. This demanding routine was stressful and arduous, yielding relatively modest returns compared to the simplicity and effectiveness of an ETF.
Therefore, adhering to the 12-15 position range allows for more focused and informed decision-making in both research and portfolio management.
Additionally, as a portfolio grows beyond 30 stocks, it becomes increasingly dependent on factor exposure. The specific stock picking becomes unimportant. The results are going to match the returns of the overall strategy. In such cases, there are exchange-traded funds (ETFs) that can replicate the portfolio's objectives with less headaches, stress, and behavioral errors. ETF’s are also more tax efficient, as an investor only pays taxes when they sell the ETF. Ideally, they can compound for many years before paying any taxes.
One of the best examples of this is the Dow Jones Industrial average. It’s only 30 stocks, but the end result closely matches the S&P 500. It slightly outperforms due to a tilt to quality, but it’s extremely similar.
A portfolio with 30 small cap US stocks with low multiples is going to resemble the performance of a small-cap value ETF like VIOV or SLYV. My old portfolio was like this, and it took years of stubborn resistance to accept this reality.
This is true for most stock picking styles. If you run a large portfolio of high quality large caps, then compare your performance to an ETF like QUAL or MOAT. If you run a large portfolio of fast growing tech stocks, then it’s going to look a lot like QQQ. If you own 50 dividend growth stocks, it’s going to be a lot like SCHD. If you own 40 large cap stable businesses, it’s probably going to look a lot like USMV.
Don’t believe me? If you run a portfolio with 30+ positions, then diligently compare your results to an ETF with a similar style for a few years. This practice will eventually provide clarity. It’s hard to admit that all of your efforts a waste of time, but they probably are. Hopefully, you won’t be as stubborn to accept this reality as I was.
Said a bit differently: yes, Walter Schloss owned over 100 stocks. The difference is that VIOV, VBR, and SLYV didn’t exist in the 1970’s. It’s the 21st century and better investing technologies are available.
To differentiate and capture returns from business dynamics and changes in investor sentiment, a more concentrated portfolio becomes essential in a stock-picking strategy.
However, a concentration philosophy can be overdone.
Highly concentrated portfolios, such as those with fewer than 8 stocks, pose a significant increase in risk. While many quote Charlie Munger on this matter, there's a tendency to overlook the expertise that Charlie brought to portfolio management and business analysis.
Charlie Munger’s concentrated portfolio included robust companies like Berkshire Hathaway and Costco, making it a markedly different strategy compared to, say, 5 cyclicals below tangible book on one end or 5 rapidly growing SaaS companies on the other.
If this is your style, then I recommend creating a screen approximating your style and backtesting it. You’ll see many years of great gains, but it ultimately results in a catastrophic year. Some examples: 2015 for energy, 2013 for gold miners, 2020 for airlines, 2000-03 for tech, or 2008 for everything.
The eventual disaster is a year with a loss of 80%+, which is effectively a permanent loss of capital. It will take a 400% gain just to get back to even. You might dismiss this and say you would somehow be able to avoid this bad fortune, or actually make over 400% later. I am skeptical.
Said a bit differently: diversification might be for idiots, but everyone is an idiot compared to Charlie and Warren.
My stock-picking portfolio consists of 12-15 positions across diverse industries with robust moats. I believe this approach strikes the right balance, avoiding the pitfalls of excessive concentration that amplifies risk, while steering clear of excessive diversification, which can be replicated easily through an ETF.
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Good article. I tend towards 30 postions, but my goal is to get to a few (like munger) that dominate the portfolio because they have compounded so much. Having 30 positions, many of which are small trackers allows me to cast a wide enough net so I have higher odds of capturing the rare compounders that I need to succeed. Also keen to avoid watering my weeds and cutting to my flowers as was my instinct in the past. Started to instead add to growing business that outperform and up since my first buy with money from the laggards that didn't work. Will it work, I'll let you know in 20 years.