Concentration vs. Diversification Pt. 1
Shedding some light on why concentration matters
“All good creative work should be drudgery. You don't find great things in large quantities. That's not part of human existence.”
— Jerry Seinfeld
He who turns over a lot of rocks, wins, is a favorite phrase of many investors when talking about idea generation. From my perspective, he who turns over the best rocks, and keeps the largest percentage of them, wins. The truth is, both go hand in hand. Keeping the largest percentage of the best rocks assumes you get the decision correct about which rocks are actually best, a hard task in and of itself. This is also not possible without having already turned over a lot rocks, developing pattern recognition in the process.
Idea selection, business analysis and exercising judgment are all important aspects of a good investment process. But position sizing is where the rubber meets the road in this business. Compounding at high rates of return for long periods of times requires a lot of things, but survival is at the forefront. As the saying goes, ‘In order to succeed, you must first survive.’
Avoiding leverage and speculation is a good start, but avoiding massive single-stock exposure is just as essential. No matter how extraordinary the business or how compelling the thesis, a 50% position introduces a whole category of risks that have nothing to do with the underlying fundamentals. A 5%, 10%, or even 15% position can survive those shocks. A 50% position probably can’t.
Having said that, I prefer portfolio concentration, and tend to hold stocks that are working, regardless of position size. The idea of concentration in investing just made sense to me from the beginning. I think it’s because in life, I also like as much of a good thing as I can get.
I would rather eat my favorite restaurant 10 weekends in a row than try a new one. When I find a pair of sneakers I like, I’ll buy 5 pairs so I can wear the same shoe for years as I wear down each pair. I spend most of my time consuming old movies, and re-reading books I’ve already read many times, as opposed to searching for new forms of consumption. I wear the same clothes most days, in the same colors, and eat the same foods.
As a result, I believe in concentration, employ it in the fund, and believe strategic, calculated risk taking among a handful of positions is a good way to outperform a diversified basket of stocks over a long enough time frame. I like to make fewer, more meaningful decisions, and like the idea of a self-driving portfolio. Concentration for me doesn’t just represent ‘less is more’, but ‘less and better’ is more.
The topic of concentration is highly debated within the investment community, with opinions ranging from in-favor to pure hatred. Like most things in investing, there is no one size fits all, and this is a topic with plenty of nuance attached. There is data and personal experience to support each side.
I began my investment career as a concentrated investor and have never really known, or seriously attempted any other approach. Even so, I continue to revisit the pros and cons of concentration as I work through how to improve as a portfolio manager. Especially because I’ve had my fair share of concentrated bets that haven’t worked out well.
The real challenge is running a portfolio concentrated enough to drive meaningful returns without introducing the risk of permanent impairment. Striking that balance is far easier when you have a genuinely long time horizon and the correct temperament to match, but it’s a difficult task nonetheless.
And that’s where the next part of this discussion begins. Time horizon, patience, and duration shape most investor’s preference for, and use of concentration.
I’ll also discuss Trata, one of my favorite new AI-powered research tools, that uses agents to interview hedge fund analysts, write investment research, and anonymously connects analysts with each other to discuss companies.
Trata gives hedge funds un-biased, unfiltered stock analysis from anonymous analysts at well-known funds. Trata captures analyst thinking via interviews, and publishes transcript libraries full of content and insights.
