Berkshire Ruminations

Friday, March 17, 2006

A few thoughts on portfolio construction

The notion that owning a few stocks is much wiser than owning many stocks should be self-evident to the Buffett follower. If an investor concentrates in a small number of stocks, he is far more likely to critically analyze and track each one. In other words, limiting one’s decision making ensures that each decision will be given more thought.

Mr. Buffett has long advocated this philosophy and often uses his punch-card analogy to explain it. He recommends that every investor should invest as if he or she has a punch card with only twenty punches available over the investor’s lifetime. Each investment represents a punch, so once the investor has used all twenty punches, that’s it. This mindset will help the individual reduce the rashness of his decision making and increase his confidence in each decision.

If you are familiar with Mr. Buffett’s strategies, you probably already know this. But what you may not know is that this theory is supported by – believe it or not – academic research. Not all academics ardently sing the praises of modern portfolio theory and efficient markets. There is a wonderful trend towards alternative explanations of market phenomena. Whether or not this trend is the result of the undeniable success of Mr. Buffett we will never know.

Two professors from the University of Michigan and one from the University of Illinois collaborated on a paper entitled “Portfolio Concentration and the Performance of Individual Investors.” The paper explores differences in concentration among portfolios of individuals. It ignores institutional investors and simply compares investments of households using data provided by a discount broker over a five year period. It finds that, in general, investors with portfolios containing a small number of stocks outperform comparable portfolios consisting of a larger number of stocks.

More specifically, large portfolios that are concentrated in a few stocks perform significantly better than the more typical diversified portfolio of equivalent size. If we can assume that investors with large portfolios (that is, wealthy investors) are typically more financially sophisticated, then these findings provide evidence that financial sophistication and critical analysis can work to help an individual beat the market.

The paper further finds that individual investors who concentrate in local stocks tend to outperform others to the greatest extent. Might this suggest that familiarity leads to better decision making? It would certainly seem to follow. The authors of this paper are quick to clarify, however, that concentration in a few stocks is only rational if the investor has above-average stock picking acuity and a sufficient informational advantage. That is, unless you know exactly what the heck you are doing, it is best to diversify.

This is consistent with advice Mr. Buffett has given as well. Diversification is protection against ignorance, he says, but if the investor is not ignorant then a focused portfolio is best. If the investor is ignorant, then a low-cost index fund is the best route.

4 Comments:

  • andy

    one of the complex things to do is one must also have a great understanding of accounting.

    as you and i have emailed each other previously. one of the difficulties as an investor is finding the right information and being able to investigate it appropriately.

    one section that i found was valueline was very helpful.

    i also recently purchased lots of books on accounting and it is fascinating. if one were to look at financial shenanigans and read the smartest guys in the room.

    it really demonstrates the need to understand the accounting method companies are using etc..

    an interesting aspect to this blog may be to go thru a stock piece by piece then having individuals comment.

    even choosing a stock that we all can look at.

    i agree with focused investing it helps with being able to look at companies.

    however, one concern that i have is if looking at a company and don't fully understand the basics underneath even utilizing the approach in the buffet workbook.

    may lead to investing in a company like enron, waste management, cendent all of which are in the book financial shenanigans......

    bb

    By Blogger gumbysgoldfinch, at 18 March, 2006 04:38  

  • Without question, this is the biggest obstacle facing investors, whether institutional or individual. Even if we do understand accounting well, how can we trust what the companies tell us?

    Still, though, the instances of damaging accounting fraud are rather rare. And experiences like Enron are definitely things we can learn from. At the time, the off-balance sheet nonsense Enron was doing was brushed off by investors enamored with the company's mushrooming earnings. But now, just the term "off-balance sheet" is a red flag. To I am optimistic things will improve, but in the meantime constant vigilance and continuing education is the best approach.

    I like your idea of having others comment on a particular stock. Once traffic increases, we should do this.

    By Blogger Andy Kern, at 19 March, 2006 08:10  

  • re: enron - ENE had negative cash flow for, i believe - it's been a while now, 6 consecutive quarters leading up to their demise. earnings can be and have been manipulated, but, cash flow is hard to fake. cash is king.

    By Blogger mike, at 04 May, 2006 19:20  

  • I am 21 years old and am just starting to learn the ins and outs of the stock market. Your blog has been really helpful in different tactics when speculating on stocks. My dad owns some Berkshire and raves about Buffet, which led me to this blog. Do you have any advice for a young student just learning the game?

    By Blogger TK, at 30 May, 2006 13:58  

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