Sunday, 4 March 2012

Concentration or diversification - For a midcap or smallcap portfolio

I was talking to a friend. Like me he invests typically in midcap and smallcap stocks. The interesting fact he mentioned was that invests only in 4-5 stocks at a time. That is, he has about 20-25% in each stock of his portfolio. His argument was that Buffet and Munger continue to advocate high concentration in stocks and also followed their own advice and had a large concentrated portfolio. I think he is taking on unnecessary wipeout risk.

My friend is like me, a purely small retail investor and makes investment decisions based on publicly available information with no recourse to management. I agree that Buffet and Munger advice a concentrated portfolio, but only if you understand the businesses very well. For a purely external investor it is very difficult to understand a small or mid sized business so well that they can bet a very large portion of their networth on it. Also, it is important to understand that for mid and small cap investing it is likely that some of your picks will go wrong. And when it happens stock prices can go down 80-90%. It is important to diversify adequately to ensure that you don't get wiped out when, inevitably, some of your picks go bad. I think it is important to have around 10-15 stocks in your portfolio and preferably not all from the same industry sector!

4 comments:

  1. So right..
    However, I feel this Buffett- Munger principle is not even followed by Buffett-Munger themselves. As of today, he has more than 60-70 businesses... No?

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    Replies
    1. I think Berkshire these days has more businesses because they have more cash than they would ideally want as pure investors. That is why you see Buffet buying utilities and railroad companies which he would not have touch with a bargepole earlier. Now he has to do it to employ the cash continuously pouring in to their coffers.
      But if you see his early days, Buffet was fairly concentrated in his portfolio and mostly worked on arbitrage opportunities.

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  2. Hi Abhishek,

    This is a favorite topic in my circle too. Concentration Vs diversification. One more topic is Beaten down Vs expensive but good quality stock. Of course the beaten down doesn't mean bad quality of stock but still...

    My thought process is, even though I (similar to you) might be small time investor's now, typically at the start of my career. We need to prepare ourselves for those years down the line when we might be managing/investing a bigger corpus. At least simply because of accumulation from our earning over this period.

    Investing in so few of them like done by your friend doesn't look like can be scaled well enough when the value of corpus increases and we are closer to our financial goals may be 10 years down the line. Losing 80-90% even from a single stock in the portfolio at such late stage can be very risky. Although at this stage it may not set us back by much because age is on our side.

    Also, like you said, since it's very difficult to understand everything about a business from a outsider's perspective so more number of stocks in our portfolio is like a insurance against our foolishness.

    Also not to forget, Buffet is a protege of Ben Graham 'the master' and Charlie had a thriving law practice and real estate business to fall back on :)

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    Replies
    1. Raja, Great points. Let me do a follow-up post on great business at a fair price vs a fair business at a great price.

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