A common thing about complex, dynamic topics such as economics, climate change, and politics is that people participating in such systems are often divided into two opposing camps with differing degrees of polarity: they’re either capitalists or socialists, believers or non-believers, right-leaners or left-leaners, etc.
Portfolio management is another one of such topics. And two tugs-of-war have divided camps over many decades.
One involves the question of whether the stock market is an efficient marketplace in which market prices fully reflect the market participant’s rational expectations for the future, and current prices thus reflect the present value of each security.
The other is about the question of diversification: how much you should diversify your investments to optimize your risk-adjusted return on the portfolio. Here, the camps are not divided evenly. The vast majority of investors believe that wide diversification is the most important practice to minimize risk since it minimizes portfolio volatility. In fact, it’s probably the most frequently given advice from financial advisers.
Very few believe low diversification, or concentrated investing, to be the less risky option. However, this is exactly the camp where the greatest investor of all, Warren Buffett, belongs.
In The Warren Buffett Portfolio author Robert Hagstrom illuminates how Warren Buffett throughout his entire career has achieved his legendary performance by managing a very concentrated portfolio with occasional huge bets on great opportunities – an approach he calls focus investing. And it’s really good. When I read it, I resonated immediately with the mental framework described. I always knew of Buffett’s history of making concentrated investments within his circle of competence, but I didn’t recognize its vital importance until I read The Warren Buffett Portfolio.
This is Hagstrom’s second book on Warren Buffett. The first was The Warren Buffett Way. While the first book first gave the reader tools to pick stocks wisely, The Warren Buffett Portfolio shows how to organize them into a focused portfolio and provides the intellectual framework for managing it.
What I find striking about it is how Hagstrom manages to keep every argument clear and structured throughout the entire book. Like Buffett, Hagstrom has a great ability to explain difficult topics in an easy-to-understand format and he connects each argument very smoothly as you pass through the book.
The Warren Buffett Portfolio is divided into two large parts where the first part introduces the concept of focus investing and its main elements including both academic and statistical rationales. The second part turns attention to other fields of study: mathematics, psychology, and the science of complexity. The book ends with Hagstrom giving clear guidance for how every investor can initiate a focus investment strategy.
Here are my personal notes on topics from the book. A summary of the key lessons learned follows.
Concentrated investments are critical to achieving market-beating returns for many years.
This is the main argument of the book. As Hagstrom states:
Before people can successfully use the focus portfolio strategy taught by Buffett, they must remove from their thinking the constructs of modern portfolio theory. Ordinarily, it would be easy to reject a model that is largely considered intellectual; after all, there is nothing prideful or rewarding about being average.
After stating the performance records of other remarkable investors besides Buffett, including Phil Fisher, Charlie Munger, Bill Ruane, and Lou Simpson, Hagstrom underlines the argument using probabilistic mathematics to show that the probability of beating the market goes up drastically when the size of the portfolio goes down.
He then isolates Berkshire’s equity portfolio from 1988-1997 in which the annual return was 29.4 percent compared to the 18.9 percent delivered from the S&P 500. This period included Buffett’s first interest in Coca-Cola which in 1988 represented 20.7 percent of Berkshire’s common stock portfolio and later in the 10-year period represented up to 43 percent. Coca-Cola delivered an annual return of 34.7% over the period.
Hagstrom then shows what would have happened if Buffett had not overweighted his positions but had simply maintained an equal balance in his stocks each and every year. This would include Buffett rebalancing his positions regularly to prevent any position such as Coca-Cola to become too big. On an equally-weighted basis, the portfolio would have delivered 27 percent annually. Then he calculates that if Buffett ran a widely diversified portfolio of fifty names of market-return stocks, he would have generated a 20.1 percent return – only 1.2 percent better than the market (excluding eventual trading costs).
“Diversification is for the know-nothing investor; it’s not for the professional.”– Charlie Munger
Hagstrom uses the Kelly criterion as a way to explain Buffett’s big bets on what he perceives as high-probability events. This is a must-read part of the book. As Junto readers know, the Kelly criterion is one of the key elements of our investment philosophy.
I really enjoyed the part on John Maynard Keynes being a legendary focus investor, although most people know him for his contributions to economic theory. Proof of his investing prowess and strategy can be found in the performance records of the Chest Fund at King’s College in Cambridge from 1928 to 1945. At the fund, Keynes explicitly outlined the fund’s investment policy report to only include concentrated investments in a select few common stocks of high-quality predictable businesses using fundamental analysis to estimate the value relative to price. During his 18 years at the fund, Keynes achieved an average annual rate of return of 13.2% while the UK stock market remained basically flat. As Hagstrom writes;
considering that the time period included both the Great Depression and World War II, we would have to say that Keynes’s performance was extraordinary.
Even so, the Chest Fund did experience some painful periods of higher than market volatility and occasions where it significantly underperformed the UK stock market. Investors in the fund obviously received a bumpier ride than a widely diversified portfolio but came out much happier and wealthier at the end.
“It is a mistake to think that one limits one’s risks by spreading too much much between enterprises about which one knows little and has no reason for special confidence… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.”– John Maynard Keynes
High portfolio turnover is a wealth destructor.
Another key lesson with Buffett’s focus investing strategy is what he calls to “move like a sloth”. Moving like a sloth simply means having a constant aversion to activity, and consequently low portfolio turnover.
The main lesson is that as long as things don’t worsen, let your investment run for at least five years (longer is better), and teach yourself to ride through the bumps of price volatility with equanimity and your perception of the investment’s intrinsic value intact. Excessive trading in and out of positions in an attempt to anticipate market price changes is not the Buffett way. And due to how capital returns on stocks are taxed, the long-term investor has a significant advantage in achieving a higher after-commission and after-tax returns over many years with a low turnover portfolio.
“You only have to do a very few things right in your life so long as you don’t do too many things wrong.”– Warren Buffett
Buffett’s famous baseball analogy from the book, The Science of Hitting, is a great way to mentally grasp this lesson. For Buffett, investing is a series of pitches and to achieve above-average performance one must wait until an opportunity arrives in the sweet “strike” zone. Buffett believes investors too often swing at bad pitches, and their performance consequently suffers. Perhaps it is not that investors are unable to recognize a good business at an attractive price when they see one; maybe the problem lies in the fact that they can’t resist swinging the bat.
Rebalancing can be irrational.
Another human tendency is a desire for order, for balance, for unity, for symmetry. This desire has its roots in our ability to sense justice and “correction” which is a marvelous uniqueness of the human species.
In portfolio management, this tendency comes to light in the concept of regression to the mean; where high-rising assets eventually must fall and poor performers must again rise.
This concept is the reason why the majority of portfolio management strategies are based on what is called rebalancing. Whenever a holding becomes proportionally larger than a portfolio’s other holdings, the portfolio manager sells a fraction of the holding to “lock in gains” and bring it down to a pre-determined target weighting. As explained in the above example, where Hagstrom isolated Berkshire’s stock portfolio into equal installments and added fifty names of market-return stocks, this is exactly how the typical [professional] portfolio is managed.
However, while regression to the mean is a powerful mental model and a common statistical phenomenon, it can be equally dangerous to assume it exists in every system. What often actually happens in the stock market and business is that industry economics and sustainable competitive advantages result in certain market-beating companies continuing to over-perform and poor companies continuing to drift.
Hence, Buffett does not believe in rebalancing. In the context of a portfolio built for capital appreciation with a very long time horizon, such practice makes very little sense. In fact, for investors having a long-term investing horizon, rebalancing is a weapon against optimal returns because it works strongly against the Kelly criterion.
Rebalancing is the act of neutralizing risks and opportunities. A way to actively take from the most dynamic part of a portfolio and re-allocate to the least dynamic part of a portfolio. At its core, it prevents any successful investment to compound to what would truly be a spectacular performance like Buffett’s record.
As Buffett wonderfully describes it:
“You would not sell off Michael Jordan just because he has gotten so important to the team.”– Warren Buffett
Volatility is not a proper way to measure risk.
The conventional way that “risk” is customarily being taught in business schools is to define a stock’s price volatility as a direct proxy for the risk of the company. This has allowed academics to quantify and isolate the “risk” component of an investment as a frequent input in valuations and statistical models.
Of course, Buffett has a different definition of risk. He defines risk as whether after-tax returns from an investment “
will give him [an investor] at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.” This means that Berkshire views risk as either a permanent loss of capital or a dissatisfactory return on capital.
Buffett’s primary concern in managing risk is “business risk”, not market risk. Simply put, how a company’s earnings manifest themselves over time. Buffett and Munger think of business risk in terms of what can happen over many years that could destroy, modify, or reduce the economic strength that they perceive currently exist in a business. It’s not quantifiable, or directly measurable, like beta, but it really is the proper definition of risk.
“If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.”– Warren Buffett
Investors too often let the irrational behavior of other market participants cause them to behave irrationally as well. Focus on what you can control and try not to worry about what you can’t. Increased short-term volatility can be a gift to the focus investor – if you let it.
Macro forecasting has no place in investing.
I truly enjoyed reading the part of the book concerning complex adaptive systems. I think it was so good that I would feel bad to include a long description of the contents in this Note. I would buy the book just for this section.
The key lesson here is that it makes no sense to try to forecast political and macro-economic trends or figures and that such projections are an expensive distraction for many investors and businessmen. However, this does not mean than an investor in individual businesses should refrain from studying the behavior of the markets.
“We have two kinds of forecasters, those who don’t know and those who don’t know they don’t know.”– John Kenneth Galbraith
Hagstrom walks the reader through classical theories on forecasting such as the Marshellian viewpoint and Newton’s determinism, which was when economics in practice started to be treated as physics, using precision – and false precision.
The book then introduces the Santa Fe Institute which specializes in multi-disciplinary studies of complex adaptive systems. Michael Mauboussin, who sits on the board of trustees (now chairman), describes a wonderful story called the El Farol problem which uses a bar attendance analogy for the type of game theory problem that exists with trying to predict the market. Just as with Keynes’s famous Keynesian Beauty Contest, the experiment describes the characteristics of a complex adaptive system, where the actual result will be determined by the forecasts of others. A great lesson is that there’s a world of difference between understanding how a complex adaptive system works and how to actually predict it.
Stock prices disengage from intrinsic value for reasons more than one, including psychological overreaction and economic misjudgment. Focus investors are perfectly positioned to take advantage of this. But, to the degree they incorporate macroeconomic or stock market predictions into their model, they will diminish their competitive advantage.
The Warren Buffett Portfolio definitely deserves a place in your library. The amount of lessons and mental framework gained from reading it is simply priceless.