Diversification vs Concentrated Portfolio

[quote=“kb_snn, post:18, topic:7526, full:true”]
There are two points in @zygo23554

  1. "Diversification is refuge of those who not willing to put hard work " [/quote]

is obviously a nonsensical statement, but that’s now what I wrote. I wrote “Diversification is the refuge of those who aren’t willing to put in the hard work it takes to run a concentrated portfolio”. This taken along with the rest of the context of my post should make my intent clear. I ain’t demeaning a diversified approach, but I am skeptical of it’s effectiveness by itself. Going by what is written by the folks at ET diversification is synonymous with safety which is wrong. I can hold 40 stocks and still get hammered out of sight if my thought process isn’t clear.

Anyway this is an opinion which people can agree to or differ with, either way I am fine as long as the person is clear about why he chooses one over the other - which is usually not the case with most naive investors who keep parotting diversification at every opportunity. I ain’t suggesting you are one :slight_smile:

I will stick to my guns on this. Compared to the average guy I have a better idea of how the rich have made their wealth (discounting those born into wealth) since I am a wealth manager by profession.

I am also drawing analogies from other fields for e.g. business - entrepreneurs find pockets they are good at, ride it till they get to critical mass and then de risk by diversifying. What creates wealth is focus, a virtuous cycle and some element of luck. Once you get beyond a threshold of wealth, diversification makes more sense than chasing a market beating approach where a setback can cost you a whole lot of money, time and effort.

If you are already rich, please diversify - that’s the most sensible thing to do.
If you aren’t wealth yet, diversification won’t do much to make you wealthy.

As for the large investors, I am sure Buffett was different as a budding investor from what he is today. I remember reading he had 50% of his net worth in a single stock in his early days that paid off big time.

However I am genuinely keen to know examples of how people became wealthy through a diversified approach and the amount of time it took them. I haven’t met any of them so far though I interact with HNI’s every day.

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Looks like you are in a mood to punish your non performers after meeting so many investors here. :slight_smile:

Situation 1: What is done is done, now you have come to place with so many knowledgable men and women. Need not worry except minimising the loss. For every holding of your portfolio , don’t allow the stock to fall below a percentage. Say 15%, this is the price for learning.:slight_smile:

Situation 2: Going forward

Your point no 2 and 3 says it all, it’s a big amount of work. Keep continuing to build your framework and share with us here. You will get plenty of valuable feedback.

Now your excel sheet- can the stock double in next 3-4 years? It’s part of your investing framework and hard work.

Imagine:

  1. If you buy a great company at a great price chances of becoming double is higher.
  2. If you buy not so great company at a great price chances are also fair.

Valuation matters a lot for double/tripple. Lets not worry about double for now. A good place always is to start with few books, they cleanse your system. You will find few threads focussing on books.

Good luck

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Thanks much for all your words of wisdom, this forum is absolutely amazing. I have gone through the threads on Investing Basic & Good books to read, and have shortlisted the following for Q1, 2017.

  1. 11th & 12th Standard Accounting books - a good place, I hope, to understand basics of accounting.
  2. Intelligent Investor by Graham
  3. PAT Dorsey DIY book & Peter Lynch’s book suggested in the thread

As far as my portfolio, waiting for some market momentum to offload stocks where conviction of growth is less/doubtful. More importantly, I think it’s more about not thinking as a stock purchase by hearsay, but more of part ownership of the business. Hence, the need to understand the business in its entirety, evaluate the risks and be judicious in judgement. Hope I can make one such investment in 2017, with new learnings and better understanding.

May I advice few books in sequence. You have choice then to read once the
ball rolls on. Pure practice books, you can pick up pen and start pinning
down notes as well.

This is what I normally tell my nears and dears who wants to test the water.

Stage 1: to familirise

Book 1: Why are we so clueless to stock market? By Mariusz Skonieczny

This book uses very simple words to tell you what is a business and stock,
basics of valuation, capital structure, economy, IPO , diversification etc.
Classic primer book.

Book 2: F wall street by Joe Ponzio

Logical forwarding from previous book, talks about business in detail,
prolonged analysis of valuation etc.

Book 3: The little book that creates wealth by Pat Dorsey

A short and sweet version to know why a company can be superior to others?

Book 4: Five successful rules of investing by Pat Dorsey

This will bring you to practice notes, time to put your work into practice
and find out the shortcomings. It’s user manual short of book covering all
major aspects of investments.

Book 5: Common stock and uncommon profits by Phil Fisher

Before moving to stage 2 it takes out from hangover of value based analysis
learnt from 4 previous books and bring a new dimension to growth and
expansion. Stepping stone before stage 2.

All books are written in simple words, short books and pure practical books.

Once you are done with stage 1 we can discuss about stage 2. This shouldn’t
take more than 2 months if you are giving 2 hrs a day.

Good wishes

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Stage 2 of my list would be: this stage is to start working on investments and refining execution skills as we move forward.

Book 6: The Investment Checklist by Michael Shearn

As the name says it’s a checklist, what better way to do an investment documentation than starting with a checklist. You get question by question , topic by topic guidance.

Book 7: Financial Statements step by step guide by Thomas Ittelson

Introduces value investing, tells you basic accounting and financial analysis. Some of the terms used by Michael Shearn will look easier through this book.

Book 8: Active Value investing by Vitaly

What is sideways market? How can value investing kills boring side ways market with quality , growth and valuation. The author introduces absolute PE model.

Book 9: You can be a stock market genius by Joel Greenblatt

Time to hunt places which are not easily visible, book dedicated to “special situations”.

Book 10: The art of short selling by Kathryn

Best way to build an bear case (what can go wrong with thesis) is having a bear mind or short seller mind. Tells you all those spots which makes you sit upright for stage 3.

Stage 3: this is the optimisation stage which includes maintain and enhance capabilities:

Book 11: What I learned loosing Million dollar by Jim Paul

Foundation for behavioural finance. First time one realise investing is 83% psychology after reading all these books. Nerve chilling story of Jim Paul’s bankruptcy and equally successful comeback with why, and what.

Book 12: Value Investing and beyond by Bruce Greenwald

Arguable an attempt by a professor to bridge business strategy with stock valuation. This book connects well with Porter five force and you will start realise DCF valuation can be hollow many times as well.

Book 13: Quality of earnings by Thornton Glove

Welcome to world of deception, how numbers doesn’t tell you all?

Book 14: Financial Schenanigans by Howard

Next stage of deception…all about manipulation and fakery.

Book 15: The most important thing by Howard Marks

I sign off with this book as it reminds the journey of 14 books as summary.

Few compendiums and special topics I would add after all stages but not during practicing hours.

  1. The Art of Value Investing: quotation board or dictionary of value investing
  2. It’s earning that count: special topic book to short list superior valuation companies
  3. The Manual of Ideas: as the name says ideas and ideas
  4. Creative cash flow reporting: attack on cash flow fakery , very important as investors rely cash flow statement to detect fakery within Profit/Loss and Balance sheet.
  5. Finally Berkshire’s letter- one can’t miss this. No need to write about this one. If someone had seen this year Berkshire AGM live they know what I am talking about. The impeccable energy and truthfulness is what is reflected in these letters.
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Many thanks for the exhaustive and structured reading list suggested, about an hour a day is what I can spend in this quest and I hope to read through the ones suggested. I am sure this list will help all new forum members as well. I am also looking at the Beginners Thread, to understand the various aspects.

http://www.valuepickr.com/basics/stock-market-basics/understanding-price-to-book-ratio/

Thanks again, much appreciated.

In support of souls like me who do not have an issue with diversification (considering dependence on incoming cashflow at monthly level for portfolio building), once I have a substantial capital , at some point of time, when market throws the best of opportunity at attractive valuation , wont mind shifting to concentrated,so, i do not have a bias of concentrated over diversified, however, some thought from Mr. Charlie Munger on the same topic

Though the article says hold vs buy decision, if you keep holding good companies without adding further n keep adding new companies to buy list as your hold has very small amount of investment but neither you intend to sell nor accumulate, it will ultimately result into a diversified portfolio.

Disclosure: At least 10 year (or one complete bull and bear cycle) of portfolio return track record is required for any logical comparison else not worth comparing as it would be difficult to segregate impact of luck n effort due to sample bias.

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A quick update on my portfolio status, with rationale for holding along with a defined exit strategy which I have considered keeping in mind the entry point, returns expectation, conviction levels on quality of BQ & MQ, and also lack of alternate opportunities in the current market up-move. Stocks Portfolio-Feb 2017.xlsx (15.4 KB)

I have completely exited from Cairn, Dion Global, Vedanta, SAIL, Idea Cellular, IDBI Bank, Bharti Airtel, Dr Reddy’s, Jet Airways, Bajaj Corp, Dena Bank, Kopran, NMDC during the recent market rally with sizeable positive returns, net of tax. Exits from these was to reduce the number of companies for better tracking, and gradually move to a manageable 10-15 stocks portfolio of high quality & growth. It has also helped me to create a cash component to make use of when credible opportunities arise.

I have taken a small tracking position on Mayur, after reading the posts on VP forum, at an entry price of 343.

My MF SIP holdings are spread across 8 funds, with timeframes ranging over 2 years to 6 months. Given below is a snapshot of performance.

My VP forum stats are below

I am learning little things regularly and trying to understand the nuances of value/long term investing. I wish I had known about this forum much earlier, but as they say, it’s never too late and I am glad to make a beginning.

Apart from help, suggestions and constructive feedback provided here along with understanding businesses, I am also learning the “ART OF COMMUNICATION” from the various discussions. Such clarity of thought and expression in many of the discussions.

Feedback and comments are most welcome.

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A quick update on the PF at end of FY 2017, have trimmed down from 44 companies to about 16. Entered a tracking position in Mayur & Divi’s, and intend to wait for annual results of the companies and read through the AR’s and take further decision. Holding about 30% of PF in cash for future opportunities or average up/down depending on the annual results and my conviction levels.

Top 3 holdings has a 35% weightage, top 5 with ~ 55% and top 10 with about 85% weightage on CMP.

Thanks!

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Purpose of this post is to try and figure out, at a given instance, should you be holding a concentrated portfolio or a diversified one? Do note that, if you are expecting a “holy grail” answer to this question then you will be disappointed! This post will attempt to answer the question; if the number of companies you should be is invested in should be towards YOUR lower range or higher range.

Point #1

Question: Why do we diversify? (Diversify in this context means investing in various companies)
Answer: To reduce risk!

Consider this: If you want 25% returns and you are 100% certain that A PARTICULAR COMPANY is definitely going to give 30% returns then shouldn’t you put ALL your money in THAT 1 COMPANY?

Reason we diversify is because we want to protect ourselves from THAT ONE UNKNOWN EVENT that can make us lose our capital!

To summarize point #1: We diversify (buy multiple companies) to reduce risk!

Point #2

Let’s put risk on a scale of 1 to 10; where 1 means least risky atmosphere and 10 means most risky atmosphere. Let’s also assume we are comfortable holding between 5 to 25 companies. (NOTE: This range can be different for different people.)

When the risk is approaching 10, the number of companies we hold should approach 25 as that is supposed to reduce risk via diversification (see point #1); CONTRARILY when risk approaches 1 the number of companies we hold should approach 5!

To summarize point #2: Higher risk leads to diversified portfolio and lower risk leads to concentrated portfolio!

Point #3

If we are settled on point #1 and point #2 then last piece of puzzle is to figure out if we are approaching risk towards 10 or 1?

This is straight-forward. If rate of increase in price is greater than rate of increase in earnings then we can say that the company is getting expensive. And buying something that is expensive is risky. And we can say that risk is approaching 10! (Basically, if PE is increasing then risk is increasing.)

Contrarily when the earnings are growing faster than the price or is price is de-growing/falling with constant earnings then we can say that the company is getting cheaper and a good asset at cheaper price is less risky. (Basically if PE is reducing then risk is decreasing. Of course, the fundamentals of all the companies that we hold should be great.)

To summarize point #3: Higher PE means higher risk and lower PE means lower risk. (For a company with great fundamentals and all other things staying constant.)

So if we put the above 3 points together than we can conclude that:

When the PE of the market (or our portfolio) is increasing then we should reduce risk by diversifying into more companies and when the PE of the market (or our portfolio) is decreasing then we hold a concentrated portfolio.

This concept looks counter-intuitive as many investors tend to increase the number of companies they hold when the market/portfolio is falling! They end up doing this as they are seeing “bargains and discounts” everywhere and the FOMO (fear of missing out) factor makes them dip into every falling stock!

PS: This is my theory and something that I have ended up following. Number of stocks that I hold has fallen from 20 to 10 when the NIFTY fell from 11K to 10K. Comments and criticism welcome!

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Degree of concentration should be a function of your hit ratio. Hit ratio is simply the number of stocks that meet your return expectations. e.g. if 8 out of 10 stocks you buy meet your return expectations then your hit ratio is 80%.

Risk is no doubt related to degree of concentration. To me risk comes from wrong expectations. Often, risk in investing lies not with the investment but with the investor. P/E ratio, beta etc captures the risk associated with an investment but in the end what matters is how an investor forms his/her own return expectations about that investment. Unrealistic expectations lead to substandard returns and lower hit ratio. Thus hit ratio captures risk that is individualized, the one that account for all the biases that goes into forming expectations and making an investment decision and the final result.

I don’t have a formula to derive number of stocks one should own as a function of hit ratio but in general higher the hit ratio higher the degree of concentration and lesser the number of stocks one should own. Based on my observations, most ace investors have a hit ratio of > 80%. At that rate, I would be comfortable holding just 5 stocks. If my hit ratio is 2/3 then I would not own less than 10 stocks. And finally if my hit ratio is less than 50%, I am better of investing in a mutual fund.

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That was an interesting way to find “the diversification number”. I had not thought about it this way!

To summarize: I should go thru each investment and ask “Has this company given me my expected annualized returns ALL thru my holding period?”

Thank you for sharing!

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I see the need for diversification to arise from qualitative factors, not quantitative. Diversification helps to reduce risk caused by uncertainties of geographical concentration, sectoral downturns, currency exposure, policy shocks or company specific factors. I don’t see it as a response to market over / undervaluation or stock returns. To me, it is agnostic of earnings, price movement, P/E ratio etc.

That is a pretty good way of looking at this.

How I’ve defined my hit ratio is - Over a 3 year period from the day I invest in a story, am I able to beat the FD return over the period by 5% p.a for any of the reasons/hypothesis I had identified when I first made the investment

Why 3 years? Since I invest with a 5 year horizon at the very least. If something does not pay off in 3 years time, chances that it will play out over the next 2 years aren’t high. Exceptions and special market situations can always prove this wrong but works well as a rule for me

Why FD + 5%? Because that is the minimum I would expect to make from a stock (of course this will be the bottom quartile of my stocks) over a truly secular period. Do not want to set unrealistic expectations based on the return generated over the past 5 years in small caps, this I believe will mean revert unless the investor is exceptionally skilled/lucky.

Exceptions - When it is clear to me that results are more due to luck than skill. For example my investment in Linc Pens is up almost 90% in 8 months, but none of the hypothesis I had built have played out yet. In such cases though return numbers say otherwise, I am not willing to call this a hit yet.

Going by my hit rate number and my willingness to live with interim volatility (which becomes pretty important temperamentally), I figure the sweet spot for me to be around the 15 stocks +/-2 mark

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The concentrated versus diversified portfolio dichotomy has divided investors since times immemorial.
Experienced investors have shared their thoughts on this thread. I’m just a beginner. My thoughts may not be value additive. But, I’ll still share them since it’ll help me refine my crude understanding, interpretation.
Concentrated Portfolio:
A concentrated portfolio construction has often been appreciated for its contribution to wealth generation.
But, first, I must define what a concentrated portfolio is- For me a concentrated portfolio would be one that is comprised of 3-4 stocks with equal weightage.
A concentrated portfolio is a double edged sword. It definitely enhances portfolio performance if the investments do well.
But, there’s a 50% chance that investments can do poorly. In such a situation a concentrated portfolio could be devastating. It’ll erode the capital.
And,when we invest, it’s crucial to appreciate the little information at our disposal. There are numerous factors involved that could lead to painful outcomes. Hence, we must consider the potential for upside but emphasis should be on capital preservation.
To summarise- Significant upside- significant downside.
Diversified portfolio:
A diversified portfolio is often advocated by those who are risk averse or have a low appetite for risk.
First, I’d like to share my definition of risk-
1)Risk is the loss of capital.
2) Risk is failure to preserve purchasing power.
Second, I’d like to define a Diversified portfolio.
In my opinion, a diversified portfolio is one which is comprised of 12-16 stocks with equal weightage from various industries
The upside of a diversified portfolio is a lower possibility for significant capital erosion.
Even if a couple of investments go bust it won’t lead to significant destruction of capital.
But, the downside is that even if a stock performs extraordinarily it’s contribution won’t be much to the portfolio.
So, to summarise,moderate upside- moderate downside.
Now, in my little understanding, the ideal path is somewhere in the middle.
Like in most aspects of life the most rewarding approach runs through the middle of both strategies.
Concentrated- Diversified portfolio is a false dichotomy. A portfolio should be prepared with the best from both schools of thought.
A portfolio consisting of 6-8 stocks provides decent diversification to protect on the downside and also provides enough concentration to ensure appreciation of the portfolio. To reduce risk, 6-8 stocks from varying industries can be included.
To summarise-
The sweet spot between the warring schools of thought is a portfolio of 6-8 stocks from unrelated industries.
Please guide if I’ve erred.

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Problem comes when we want to become someone else and then try to think concentration , diversification more from what others did than what suits us. I think we should stick to what suits our style and of course be aware of pros n cons of both approach. Even for the same individual , at different phases of age and portfolio size , strategies would differ . Based on behavior of churn , in different market cycles , answer would differ for same person. There r bottom up investors n then there r successful top down investors who bet on sector themes with high probability of success n there too , answer will differ. Don’t think one size fits all . Lot of analysis is available for market as a whole but we must be cognizant of facts that outliers are always away from normal ,so, it won’t apply to them. The one who become outliers they master what suits their intellectual, behavioral and psychological strengths

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I find investors who are extremely well aware of future prospects of industry and their invested company within that industry management outlook etc can have concentrated portfolio but most of us have to depend on 2nd hand information and data base as is publicly available hence our conviction can only be lukewam Portfolio concentration can only be a function of our conviction in our stock stories

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I agree with this. Diversification is a protection against the unknown. If you know the company in and out or if you have a say in how the company operates, it makes sense to concentrate your holdings. Otherwise, diversification is inevitable. One more reason I can find in support of Concentration is the lack of better investing opportunities.

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Patience is a great asset for an investor he must wait and wait till a convincing opportunity presents itself. I have learnt this in the last 30 years of my investing carrier ``

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Does anyone follow Gary in Quora? He’s fantastic. He wrote an article for the CFAI recently:

https://blogs.cfainstitute.org/investor/2018/04/23/portfolio-concentration-how-much-is-optimal/

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