Thursday, April 24, 2014

Carefully crafted concentrated portfolios better than diversified?

Carefully crafted concentrated portfolios typically are preferred by value investors. This sounds very counter-intuitive to someone who has studied the efficient market hypothesis and mainstream finance as people will tell you to diversify as much as possible.

Diversification is a method of reducing risk by buying several companies which may or may not be good quality or at the right price and about which you have little to no knowledge about. Value investors will tell you that finding 10 opportunities in any market is difficult. Finding 100 opportunities is probably impossible. And if you do find a 100 opportunities you can probably analyze and rank them and the top 10 or 20 are likely to be far better than the bottom 10. The higher the diversification the higher the probability of being closer to the market returns - the only way you beat the market is by running a concentrated portfolio.

Secondly value investing is a careful art typically run by small teams typically even single decision makers. Remembering details of 15 stocks is challenging, 25 is probably the limit for most, and 100 is probably impossible. Also even though you might maintain spreadsheets and databases the factors being judged in value investing are largely abstract and have to be analyzed in the person's head and that requires the person to keep a close watch on each holding with utmost care. That care gets very diluted if the positions increase.

Critics of value investing would argue that a concentrated portfolio will generate higher volatility. This may or may not be true but is irrelevant to the value investor. The sharpe ratio theorists will tell you that higher volatility means higher risk and therefore the return expectation needs to be higher to hold the portfolio. The sharpe ratio is a beautiful concept where you try to get more reward than the risk you take but I think the definition of risk in the context of value investing should be 

  • Price: The discount to the the underlying value of the asset or company the stock is bought at
  • Value: The probability of the underlying value going up versus going down
The ups and downs of the stock value on the market is not a source of risk but a great opportunity for value investors to buy and sell a company at the right price. 

Overall hopefully I have convinced you that you do not need to hold a 100 stocks to reduce risk. Its far easier to reduce risk by buying at rational prices.

Please do write in, comment or call me if you have any interesting comments questions or concerns. My contact info is on the main website.