Getting above-average returns in the stock market is not only a function of picking the right stocks. It is also a function of structuring your portfolio in a clever manner. Warren Buffet is the greatest investor of all time. So I think he is the best subject to study to learn about portfolio allocation.
In this summary, you will learn that his approach, which could be called Focus Investing, differs a lot from what you might have heard before and or have been taught in school. This is a top-five takeaway summary of the Warren Buffet Portfolio written by Robert Hagstrom.
Takeaway #1: Focus Investing
Perhaps you noticed in the introduction since 1980 Warren Buffet has almost always had the top five companies of the portfolio of his company, Berkshire Hathaway representing more than 50% of the total. In 1990, they were almost 70% of the total. And this was at a time when the company had close to a $10 billion valuation, or in other words, it had quite a large portfolio. This approach could be called Focus Investing. The essence of it is this: Bet big on a few stocks that are likely to produce above-average returns over the long run and stick with these stocks through short-term fluctuations. There are many advantages to this approach compared to the ultra-diversified portfolio that many of the money managers on Wall Street run these days.
Firstly, it reduces costs. There are many things that are quite unpredictable in the stock market, but costs is not one of them. A focused portfolio reduces the costs of investing both in terms of transaction fees and in terms of taxes. The difference between running a high-cost portfolio and a low-cost one is quite astonishing.
Secondly, it increases your chances of over-performance. Before writing this book, Robert Hagstrom ran a simulation, testing how 3000 randomly generated portfolios would perform during a period of 10 years. 3000 portfolios with 250 stocks in each, 3000 with 100, 3000 with 50, and 3000 with 15 stocks in each. This study show some interesting results. Among the portfolios with 250 stocks in each the maximum returns of any portfolio during the period was 16% annually. Even this best of performing portfolios didn’t over-perform the general market in any significant way. Among those with 100 stocks, the best one had 18.3% yearly returns. 50 stocks, 19.2%. And finally, among the portfolios consisting of 15 stocks, 26.6%.
So focused portfolios beat the market by significant margins, much more often than diversified ones. Coincidentally, they also underperformed the market to a significant degree more often when you look at it from a theoretical standpoint, but I’ll explain why this isn’t necessarily the case in practice in the next takeaway.
Thirdly, it reduces risk. Yes, reduces. When risk is defined in the only manner that risk can intelligently be defined in, it lowers the risk of your portfolio to use focus investing. You learn why in takeaway #3.
Takeaway #2: The higher the probabilities, the bigger the bets
According to Warren Buffet, “Take the probability of loss times the amount of possible loss, from the probability of gain, times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” Inevitably, some stocks will have higher probabilities for above-average returns than others. As a focused investor, you should tweak your portfolio accordingly.
The outstanding returns of Warren Buffett’s Berkshire Hathaway can to a large extent, be attributed to the fact that he was willing to bet big when the odds were overwhelmingly in his favor. Berkshire wouldn’t have been Berkshire without large bets in companies like Geico, American Express, Coca-Cola, Wells Fargo, and BNSF Railway.
An interesting corollary to the fact that you should bet bigger the higher that probabilities are is that you should always use your current best holding as a benchmark for buying new ones. For example, if you own Apple currently, and you’ve calculated that the company should be worth something like two times more the current price of the stock, you shouldn’t add companies that are worth less than that to your portfolio. Quite frequently, the best investment to make is to double down on something that you already own.
On Wall Street, just the opposite approach is used. If a holding advances to become a large part of their portfolio, they typically sell parts of that company to invest in other companies. But this is madness. Trading away your largest holding just because it has come to dominate your portfolio is very similar to saying that Barcelona should trade away Lionel Messi because he has become so important to the team. Crazy. According to Warren Buffett’s right-hand man, Charlie Munger, “Not using probabilities for investing is like being a one-legged man in an ass-kicking contest. You’re giving away a huge advantage to everyone else.” When deciding how big you should bet you can use something called the Kelly Formula, which you can learn about in our summary of the Dhandho Investor.
Takeaway #3: Is focus investing super risky?
The answer is NO.
Maybe I should elaborate a little bit. I bet you’ve heard from many different sources that as an investor, one must diversify.
“The one universal rule that idiots in finance know is diversification. It’s the only free lunch. You’ve got to diversify.”
“Diversification is crucial.”
“And the more diversification you can get the better.”
“Single stocks are a bad place to invest money. They’re much better off to be spread out and well-diversified.”
And it isn’t such a bad idea. Even Warren Buffet himself admits that for the know-nothing investor, it is a great option to periodically invest in index funds. These will give you a high degree of diversification and you are pretty much guaranteed to receive the average market returns. But the ambitious investor should ask himself this, “Am I satisfied with average returns? Can I do better?” Let’s look at why someone would diversify.
Diversification means buying many different stocks so that a single one of them, or just a few of them can’t have a large impact on the portfolio. And this is inevitably true. If you own 100 companies in your portfolio and you bet 1% of your capital in each of them, you cannot lose more than 1% on any single company. Even if this company ends up in the worst bankruptcy in history. If you own 20 stocks in a similar fashion, you stand to lose 5%. If you own 10 stocks, 10%, et cetera.
The opposite is of course also true. In a portfolio with 100 companies, each representing 1% of the total, you cannot gain more than 1% should any single one of the stocks in it double. 20 stocks, and you can gain at maximum 5%. 10 stocks, and you can gain 10%. What diversification gives them is reduced volatility. Your portfolio will fluctuate less and less the more companies you add to it, given that the stocks of these companies do not move in tandem, of course. But risk is not volatility. If your portfolio fluctuates a lot, who cares? Is this a bad situation? Not necessarily because it probably means that you can buy more of the great companies that you already own at bargain prices. Is this a bad situation then? Well, a few would question that, but it could mean that your companies are overvalued and that some of them should be exchanged for lower valued ones, or it could simply mean that your companies are doing great.
Risk is not knowing what you are doing. If you add an additional 90 companies that you don’t know much about to a portfolio of 10 companies, which you do know a lot about just for the sake of diversification, you have just increased your risk, not decreased it. Not knowing enough about 90% of what you own, how can that possibly be a reduction of risk? Risk will decrease the more knowledge you have and you have the possibility of having more knowledge about your portfolio, the fewer companies that you have in it.
Takeaway #4: An alternative portfolio benchmark
Perhaps you noticed in the introduction the portfolios that I presented represent the earnings of Berkshire Holdings as a part of total earnings and not the market values of the holdings as part of the total. The reason for this is twofold. Firstly, it was difficult creating these illustrations as it involved a lot of assumptions and guesstimates. It would have been even more difficult if I tried to convert Berkshires wholly-owned subsidiaries into market values. So yeah, the first reason is that I was kind of lazy.
Secondly, earnings is the ultimate yardstick of the intelligence investor. Warren Buffet says the following: “The goal of each investor should be to create a portfolio that will deliver him or her the highest possible earnings a decade or so from now.” As disgusting in the last takeaway, focused investors will have portfolios, which fluctuates a lot. To be able to handle this mentally, you must become a master bump ignorer.
Take the returns of some of the greatest investors of all time, such as John Maynard Keynes, Warren Buffet, Charlie Munger, Bill Ruane, and Lou Simpson. Notice how they have performed compared to the S&P 500 over the years. Their returns have fluctuated a lot. Sometimes they have underperformed the market over several years, but over the long run, their portfolios have had huge returns. One reason why they were able to stay the course, even during times of turmoil is because they focus on the companies that they own and not the price that the market sets on these companies. One way to do this is to look at earnings instead of market values. Earnings will fluctuate much less and over time they will decide how successful you are as an investor. The market may ignore business success for a while, but eventually it will confirm it.
Takeaway #5: The Warren Buffet principles
You’ve learned about how to concentrate your investment portfolio around great businesses, but what actually makes a superior business. Here is a short checklist of some of his most important principles.
Business principles: Do you understand the business? Is the history of the business consistent? Does the business look promising in the long run?
Management principles: Are the managers rational? Are they honest with shareholders? Do managers show independence of thinking?
Financial principles: Focus on return on capital. Find out what the owner’s earnings are. Look for high profit margins. $1 retained in the business must always produce more than $1 of market value.
Market principles: What is the value of the business? Use a margin of safety. Buy the stock at a price which represents a comfortable discount to the value of the underlying business.
When you are trying to pick great companies on your own, there are two ways to go about this. You can go from left to right, first looking for great businesses, then considering the management, then the financials, and finally the price. With this approach, you only look at the price of a company, for example, if you first confirmed that it’s a good business with good management and good financials. The other approach is that you start with the financials and then go from left to right. This approach might be quicker as you can sort companies out quickly using a financial database like screener.co or Capital IQ.