Concentration is better than diversification

[Steven Barrett]

Good point, Steven. Maybe I'm just trying to inject a bit of stimulation. I do have to admit the thought of slapping my cash in someone else's fund makes my eyes glaze over a bit. I want to have a bit of fun with this.

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings." - Warren Buffett, the world's most successful investor.

Having fun has nothing to do with it. It's capturing the power of compounding that will make you money, not the thrills of highs and lows. Boring is better.

Also good questions. Part of my answer is that the fund manager has to stay invested all the time. To quote one of them: "there's no other game in town". I, on the other hand, don't have to. My needs are few. I can cherrypick the best value buys or I can stay away altogether. Ok, I still have to figure out what they are, but with only needing to trade a handful of times a year I can buy the significant dips (along with learning a bit of analysis along the way). And let's not forget that most active fund managers don't outperform the market either.

Not everyone has to stay invested, plenty of fund managers can move to cash if they want to (remember, you are competing against every fund manager in the world). But you said lots of other interesting things:

You can cherrypick the best value buys - how will you know they are the best value? What level of analysis are you carrying out to come to this conclusion? Remember, you are competing against companies that have millions in resources and lots of experienced analysts to analyse the same stock. How can you do better?

You ca buy the significant dips - are you going to try to time the market? How are you going to do this? You may get lucky once or twice but overall, timing the market is a mugs game. Bounces in markets tend to happen pretty quickly. Missing even the best 5 days of market returns over a 20 year period can cost you 2% per annum.

Yes, fund managers don't perform the market. They are professionals and are still unsuccessful, why do you think you can do better? Try to capture the market. If you are going to take a concentrated approach and want to make money, pick the top 5 companies off a small cap index and strap yourself in for the ride.

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

 

[cremeegg]

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings." - Warren Buffett, the world's most successful investor.

Having fun has nothing to do with it. It's capturing the power of compounding that will make you money, not the thrills of highs and lows. Boring is better.

Having fun has everything to do with it. I think Warren Buffett has more fun than most. Making and backing your own decisions is lots of fun.

You can cherrypick the best value buys - how will you know they are the best value? What level of analysis are you carrying out to come to this conclusion? Remember, you are competing against companies that have millions in resources and lots of experienced analysts to analyse the same stock. How can you do better?

If anyone wants a start on actually answering this question, I suggest Jim Slater's book "The Zulu Principle"

 

[dub_nerd]

Take the US market over the course of its history (I think it's 1871 to present day).

Taking a one day time horizon, and all observations over the period, investors have been up 52% of the time. Not far off a coin toss.

However, taking any 20 year time horizon, an investor has NEVER been down.

I'm not sure that tells us anything much. There are lots of noisy data sequences that show a general trend (e.g. sea surface temperatures, change of day length due to tidal dissipation etc. etc.). So what happens if we take a random sample of days from a twenty year sequence of market data and ignore the rest? My guess is the trend will still be up. Of course, it will depend on how sparse your sample is, with greater divergences the more sparse you go.

20 years is absolutely arbitrary. As is 6 months. There's nothing scientific about it.

You mention 'beating the market every year'. Why are you using an arbitrary time frame like a year? It just happens to be the time it takes the earth to orbit the sun. What has it got to do with investing?

Absolutely nothing. That's why I said I wasn't suggesting this as the metric. I was just challenging the people who were saying "20 years" to come up with some quantifiable metric.

I suppose the 'best' time frame is the amount of time it takes to reach your investing goal. If you're able to cash out and retire with market beating performance then I'd say you're strategy has worked. Until then it's still under investigation. This is an excellent reason to use a 20 year time frame.

But I've already cashed out and retired, and I certainly didn't use anything as chaotic and arbitrary as the stock market to achieve it. So I don't have an investing goal, as such. It's more a kind of learning experiment.

Diversification is part of accepting the idea of the efficient market...

The question which is better, diversification or concentration, is based on a false premise. Each has a different function.

If you want the markets to work for you then you should diversify. If you think you can identify market errors, then you must concentrate.

I'm not sure I accept your first premise. Diversification is a way of avoiding certain types of risk. Apart from that, it guarantees that you will not achieve the best returns available, since by definition an average can never be as good as the best. But I accept your other points. And I suppose my view is that the markets are only efficient in the medium term, and highly sentiment driven in the short term. You will find lots of successful investors who say you need to be doing what everyone else isn't. I've taken an element of this approach and found it useul so far.

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings." - Warren Buffett, the world's most successful investor.

Having fun has nothing to do with it. It's capturing the power of compounding that will make you money, not the thrills of highs and lows. Boring is better.

Ah, but we're in violent agreement here. I'm not advocating a whirlwind of frequent trading either.

You can buy the significant dips - are you going to try to time the market? How are you going to do this? You may get lucky once or twice but overall, timing the market is a mugs game. Bounces in markets tend to happen pretty quickly. Missing even the best 5 days of market returns over a 20 year period can cost you 2% per annum.

It's possible this year has been an exceptional year. The market has reacted ridiculously negatively to various events -- Brexit, Trump, Fed announcements etc. I've made some nice gains from that. People always talk about the efficient market, but over short periods sentiment has a huge bearing (in my limited experience).

Yes, fund managers don't perform the market. They are professionals and are still unsuccessful, why do you think you can do better? Try to capture the market. If you are going to take a concentrated approach and want to make money, pick the top 5 companies off a small cap index and strap yourself in for the ride.

We're in violent agreement again. Am doing some of that for next year.

Thanks folks -- very useful and interesting to bounce this stuff around, hope I'm not offending anyone's sensibilities.

 

[Gordon Gekko]

That is nonsense. Markets have reacted positively to Trump's election. You're making it up as you go along.

 

[dub_nerd]

That is nonsense. Markets have reacted positively to Trump's election. You're making it up as you go along.

They didn't on the morning of November 9th. It was a pretty short blip admittedly, but why would I make it up?

 

[Duke of Marmalade]

My tuppence worth.

Why invest in the stockmarket at all? Not because you are investing in real assets which deliver real economic benefit, that seductive old chestnut. You are buying in a second hand market so these fundamentals are completely subsidiary to whether you are getting a good price. Apple is I am sure a wonderful company with lots of highly skilled tax advisers as well as some techies. But whether Apple is therefore a good investment depends entirely on its price.

There is past evidence that because of the various risks attaching, both short term and long term, the market does price in a "risk premium" for equity investment. Each individual will have a sense of whether she requires less or more risk premium than the generality of market participants. Thus if she has a long term objective and is untroubled by short term volatility she could reasonably take the view that the market is providing unnecessary compensation for that short term volatility and she is therefore getting a free lunch.

On the other hand, if for whatever reason she is much more perturbed by short term volatility than the average market participant, she is not getting sufficient compensation, and stockmarket investment is not for her.

The theory goes that the market gives no compensation whatsoever for idiosyncratic risk because that can be diversified away. Thus if you chose to concentrate you are taking on extra risk with no expectation of a market compensation for that risk. But you may not need compensation for the extra risk, you may actually want the risk for it is true that diversification will deliver you only the average return, and risk is for the upside as well as the downside. Arguably, if you are in this latter category you are more of a gambler than an investor.

I agree totally with SBarrett that none of us have an inherent skill in picking stocks. dub_nerd has been lucky over the recent past, but I will never, ever believe she did this on merit, not even if she earns 20% for each of the next 40 six month periods

As a secondary point, the Duke has a view that with the unprecedented intervention in the financial markets by Central Banks (QE), markets are not pricing in much, if any, risk premium at the present time.

 

[dub_nerd]

Good post Duke. However, this bit is nuts:

I agree totally with SBarrett that none of us have an inherent skill in picking stocks. dub_nerd has been lucky over the recent past, but I will never, ever believe she did this on merit, not even if she earns 20% for each of the next 40 six month periods

Everyone must sometime deal with statistical evidence, and making five times the average market return every year for 20 years would render it a practical impossibility that there wasn't some successful strategy being employed. (Not that I remotely expect to do that! )

 

[Duke of Marmalade]

dub_nerd it is a question of Bayesian a priori assumption (are you impressed?). For example, my a priori assumption is that the chances of having a skill in picking winning lotto numbers is 0%. If my next door neighbour wins the jackpot and claims it was skill then, despite the statistical chances of him winning being millions to one, I would still insist that he had no skill in the matter despite the statistical evidence.

Now, do I a priori believe that the chances of dub_nerd having a (meaningful) skill in picking stockmarkets are 0% (nothing personal I assure you). Well yes, close on, so no amount of statistical evidence will persuade me otherwise.

 

[Rory T Gillen]

The best returns can accrue to those who can identify undervalued assets consistently. But I doubt that's the amateur, but rather the professional investor. If you commit the time, effort and patience to becoming a professional investor you have a chance. Anything else is either arrogance or ignorance.

I'm with Brendan on this one. For the vast majority of retail/private investors diversification is important because it diversifies risk, and if one is honest it is tricky to understand or identify risk; in individual stocks this means the business, financial and valuation risks. If all stocks are overvalued, diversification within equities does not necessarily lower your risk. For that you need an asset that both offers some value and generates its returns in a way that is not related to how stocks generate them; by investing in, say, government bonds. Diversifying into other asset classes lowers risk as it reduces one's dependence on the economy for returns - the economy drives the majority of returns delivered by equities and property. If an economy is going into recession, for example, corporate earnings will suffer, and stock markets will most likely be falling. But such an environment benefits government bond prices as investors seek them out for their safety of principle and pre-determined interest (Greece, Russia et all excepted!). So owning both stocks and government bonds can lower risk. Returns may be lower too, but that's the price for reduced risk.

 

[Jim2007]

Yes, fund managers don't perform the market. They are professionals and are still unsuccessful, why do you think you can do better?

Being a professional fund manager does not imply one is a skilled investor! Assuming the funds constituents are known and publicly traded there is no reason that a knowledgeable person could not out perform a fund manager on a regular basis, but that does not mean that the individual is skilled investor either. It just means the deck is stacked against the fund manager!

The fund manager starts out with several disadvantages:
- first there is the regulations which may prevent you from fully replicating the benchmark
- next comes the float, this is the percentage of the fund that needs to be in cash to account for the exiting investors
- then there is the need to attract and keep investors, so you better be holding what's trending or you'll be in trouble
- retros can also become an issue with distributors as well
These are just some of the things the fund manager has to overcome to achieve the benchmark.

 

[Brendan Burgess]

- retros can also become an issue with distributors as well

Hi Jim

Very interesting analysis.

What are "retros"?

Brendan

 

[dub_nerd]

dub_nerd it is a question of Bayesian a priori assumption (are you impressed?). For example, my a priori assumption is that the chances of having a skill in picking winning lotto numbers is 0%. If my next door neighbour wins the jackpot and claims it was skill then, despite the statistical chances of him winning being millions to one, I would still insist that he had no skill in the matter despite the statistical evidence.

Yes, very impressed, Duke

However, the whole point of Bayes' Theorem is that you are supposed to update your belief based on the evidence. The a priori odds of your neighbour winning the lottery may be a million to one, but if he comes to you and tells you in advance that he's going to win it that very night and he does ... then you would be right to strongly suspect that he has some sort of system going. The people who funded the MIT students' lottery syndicate did not think the odds of winning the lottery were a million to one. They might have worried that they were the victims of some sort of elaborate wire fraud, but they'd have been silly to worry that the students' success was based on pure luck with all the evidence to the contrary.

Now, do I a priori believe that the chances of dub_nerd having a (meaningful) skill in picking stockmarkets are 0% (nothing personal I assure you). Well yes, close on, so no amount of statistical evidence will persuade me otherwise.

But forget about me for a minute. Would you accept that within the stock markets there is a continuum of risk available to investors, and that some investors may do better or worse than the average by choosing their level of risk? And perhaps part of that continuum of risk is the choice of level of diversification?

 

[Duke of Marmalade]

dub_nerd forget the Bayesian stuff, that was just a bit of festive banter
There is a popular fallacy that risk implies reward or rather the expectation of reward. A clear counterexample is walking blindfold across a busy motorway. Extremely risky with very high negative expectation of rewards.

Now second hand financial markets could plausibly reward risk through the pricing mechanism. That is, the higher the risk the lower the price and ergo the greater prospects for reward. However, the theory goes that if a risk can be diversified away the price will rise to a level which does not reward this diversifiable (idiosyncratic) risk.

Yes there is a continuum of risks in the market. But if you concentrate you will inevitably incur risk which the main market can ignore because they can diversify it away, so you can expect no extra reward for taking on that extra risk.

All very theoretical EMH stuff but I for one, and I think I can read a balance sheet as well as the next guy, have no illusions that I will ever be able to pick out stocks with a higher reward expectation (i.e. priced cheaply).

 

[dub_nerd]

I accept all that Duke, but what I've been doing has not much to do with reading balance sheets. That would imply holding stocks across entire reporting periods. I'm more interested in significant swings that seem to depend primarily on market sentiment. The market may be efficient in the long run, but it spends plenty of time being an emotional wreck . I'm looking for swings of 5% to 10% in a stock and aim to hold it for no more than a couple of weeks. One stock (which shall remain nameless) yielded me 18% by holding it for about 8 weeks total over a few months, with the stock price the same at the end of the period as the beginning.

 

[Fella]

I get what your doing dub_nerd , I think it's possible to beat the market return doing what you do, there are traders that do.

I beat Betfair similar strategies and have done every month or so for nearly 10years it's possible to beat efficient markets with the right strategy.

If you look at the trump odds to be president there where days where trump started the day 5/2 on Betfair and finished the day 5/2 on Betfair but in a million might of been matched on that day and there where people like myself that made lots on that day.

I'm just a little confused with your posts it's like comparing apples and oranges imo. It reads to be that you have a small hobbie trading markets using news and your opinion but your debating with people who are investing for pensions and future that want market returns.

Personally I do both and don't count them the same way , so I've 90% of my money in investment trusts which I just add to regularly it's not up that much it's been up and down but when Sterling got weaker it didn't help. But I have 20k fun money I split this up and use it for trading , I'm up nearly 50% on this money I think I'm using similar strategies that you are. The problem I see with this money is eventually I'm liable to end up with a lot of dogs that I bought and ended up holding onto and price never came back , so I don't really have a concrete plan as such so would never use the 90% of my money on this strategy. When I traded Betfair the markets where not infinite so you either got out at 70mins at a loss in football or waited to 90mins and lost it all.
So at the moment I'm taking kinda scalping the stock market not for huge swings but I've sold the winners at profit but the couple of losers I'll be left with, so long term what I see happening is an extended bad news after bad news will see me running out of liquidity to buy more and miss the next upturn or long term say for every 5 new stocks I buy if one doesn't come back I'll quickly end up with all my money locked up on the losers . ( hope that makes sense !)

Of course you can make money been a trader doesn't matter what you buy or sell it's more important when you buy and sell .

 

[Duke of Marmalade]

Being a professional fund manager does not imply one is a skilled investor! Assuming the funds constituents are known and publicly traded there is no reason that a knowledgeable person could not out perform a fund manager on a regular basis, but that does not mean that the individual is skilled investor either. It just means the deck is stacked against the fund manager!

The fund manager starts out with several disadvantages:
- first there is the regulations which may prevent you from fully replicating the benchmark
- next comes the float, this is the percentage of the fund that needs to be in cash to account for the exiting investors
- then there is the need to attract and keep investors, so you better be holding what's trending or you'll be in trouble
- retros can also become an issue with distributors as well
These are just some of the things the fund manager has to overcome to achieve the benchmark.

Interesting points. But note that the "problems" arise because the fund is open, open to exits and open to new business. Closed UK Investment Trusts have neither of these disadvantages and also because they are taxed at CGT pus Income Tax, much better than open Exit Tax funds.

 

[dub_nerd]

I'm just a little confused with your posts it's like comparing apples and oranges imo. It reads to be that you have a small hobbie trading markets using news and your opinion but your debating with people who are investing for pensions and future that want market returns.

Yes and no. I retired just after my mid forties, not sure if it's forever, wouldn't mind making some more money from investments but not prepared to jeopardise retirement altogether if I can help it. So it's a good bit more than a hobby but less than life-changing.

Personally I do both and don't count them the same way , so I've 90% of my money in investment trusts which I just add to regularly it's not up that much it's been up and down but when Sterling got weaker it didn't help. But I have 20k fun money I split this up and use it for trading , I'm up nearly 50% on this money I think I'm using similar strategies that you are.

I've got about 80% in cash, and 20% in stocks of which 20% of that is in sensible investment trusts. That still leaves a substantial amount of money that I've been trading. It's been doing moderately well. I'm not a huge spender, so actually it's been earning more than my entire outgoings. But that could be just luck. I guess that's what I'm trying to find out here. The likelihood that I've found some magic winning formula that has eluded everyone else is nil. My best theory so far is that this year's market volatility is exceptional. In a boring steadily rising market I'd probably be shut out, looking for dips worth buying.

The problem I see with this money is eventually I'm liable to end up with a lot of dogs that I bought and ended up holding onto and price never came back , so I don't really have a concrete plan as such so would never use the 90% of my money on this strategy.

Yes, same here. Fortunately I only have one dog from a couple of years back when I really had no idea what I was doing. In my naive way of thinking, if you can make 50% returns on 20% of your money, that still represents a pretty decent return on all of your money. On the other hand, if you only have 20% of your money invested you are not subject to the same level of market risk. I think that's where I differ from the other people on this forum. They need diversification to offset company- and sector-specific risk, presumably because they've got a big proportion of their assets invested. They are not protected from market risk, but that's ok if you have a long investment horizon. I'm not afraid of concentration in an attempt to get bigger gains on a smaller outlay, but am not prepared to risk everything.

So at the moment I'm taking kinda scalping the stock market not for huge swings but I've sold the winners at profit but the couple of losers I'll be left with, so long term what I see happening is an extended bad news after bad news will see me running out of liquidity to buy more and miss the next upturn or long term say for every 5 new stocks I buy if one doesn't come back I'll quickly end up with all my money locked up on the losers . ( hope that makes sense !)

Yeah, makes total sense. My approach with the losers is to bite the bullet and sell them at a loss. As you say, otherwise you will watch the other stocks rising that you could have been invested in, while you remain hitched to the wrong wagon. It doesn't always work out. I took a loss on a stock that would have been in a five-figure profit two days later. In another case I sold at a loss, then bought back in later at an even lower price and ended up with a decent gain. I try not to waste time lamenting the "ones that got away".

Obviously this strategy is fatally flawed if you have a bad enough string of losses. You'll be like the guy at the roulette table doubling down on red at every spin. Probability dictates that you will run out of liquidity at some point. I'm trying to find out if that is the inevitable long term result, or if there is a way to maintain enough of an advantage (through knowledge of market value) to keep ahead.

 

[Steven Barrett]

There is a popular fallacy that risk implies reward or rather the expectation of reward. A clear counterexample is walking blindfold across a busy motorway. Extremely risky with very high negative expectation of rewards.

Don't go around saying things like that!! We have a hard enough time explaining investment risk without you throwing in walking across motorways blindfolded!!

Indexes or a good fund manager are a good way of separating the good risk from the bad risk. Knowing that while Greece is offering 19% interest on its 10 year bonds but the chances are you won't get your money back. That 90% of companies in Silicon Valley will fail before you get the one massive return from the next Uber. Unfortunately, a lot of people are blinded by the 19% annual return or reading how someone invested in Uber and made a fortune without knowing about all the other companies they lost all their money on.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

 

[IsleOfMan]

So looking out for value buys and concentrating on a very small number of stocks seems to me to be reasonably sensible. So far I've managed to make a return of about 20% in six months while testing this strategy, though obviously that is much too short a time period to draw any inferences.

I did this myself for a period of time. I concentrated on about a dozen U.K. shares. Read everything about them. Knew everything about them. I watched their live trades online daily. Making money.

Unfortunately I got bored. Started talking to other people. Added a few shares I knew little about. 30 trades of profit in a row were wiped out with one big loss.

Trying to discipline yourself and not getting to believe that you are invincible becomes a daily battle.

 

[Jim2007]

I took a loss on a stock that would have been in a five-figure profit two days later. In another case I sold at a loss, then bought back in later at an even lower price and ended up with a decent gain.

So you have a problem in stock valuation, which is the case with most average investors and why they should be index investors rather than buying individual stocks.