In this article, you’ll learn why concentration is key to higher returns and how to do it safely for your portfolio. Sizing your positions matters just as much as what you pick. Both research and practice have shown that fewer positions are the key to outsized outcomes.
It’s not just about taking big positions, which will get you killed.
The key is to find situations where the odds are in your favor. And still, be diversified. That’s how you can improve your returns without increasing your risk too much.
Let’s dive in.
Concentration is key to outperformance.
“The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig.” Stanley Druckenmiller
To beat the index, your portfolio must be different than the index.
As I argued in my book, “Better Investment Decisions,” most active managers underperform their benchmarks because their portfolios are too similar to the index.
Researchers found that funds that are different from their benchmarks outperform. And when managers concentrate on leaders, their performance improves.
The index itself is a concentrated strategy. The S&P500 index allocates a greater weight to the largest companies. This works because, in many industries, the largest companies have better returns as they grow.
Throughout market history, only a few companies generated almost all the market’s returns. Concentrating on single stocks is how you take performance to the next level.
I know a nurse who retired after just six years of investing, with a 43% compounded annual return. He concentrated his portfolio on a growing industrial company, Atkore.
That stock 10x’d in price.
Probability AND Odds Matter.
Expected value (EV)=(Probability of Upside×Value of Upside)+(Probability of Downside×Value of Downside)
The simple formula to calculate the odds of an investment
You want to concentrate where the odds are in your favor. For many years, my mistake was thinking that all I had to do was think about the upside and downside.
I bought Playboy’s stock, thinking the new management team could 10x the company’s revenues in a few years. The problem was this team had no experience with execution.
The upside was there. But the probability of success, in hindsight, was low. This stock dropped 80% from its IPO.
It’s the same problem with lottery advertisements. You’ll see what looks like favor odds, “What if… I could win a billion dollars,” without the probability adjustment (1 in 300 million).
As course-takers in the Stock Investor Accelerator program learn, when we apply probability and odds together using decision trees, we can identify favorable situations.
You want to calculate the expected value of the upside vs. downside to determine your odds.
When I concentrated on quality stocks like MSCI with both favorable odds, the returns of my portfolio and my clients improved.
A company like MSCI, a leader in the index industry, has a high probability of staying a leader because of several competitive advantages.
The business is both recurring and essential to customers, which reduces the downside.
MSCI also has a few growth businesses, like the environmental, social, and governance (ESG) investing businesses, which improves the upside.
MSCI is up 360% (and counting) since I first recommended it to my former clients.
Diversify the risk.
An illustrative example of lowering portfolio volatility by increasing the number of assets
In order to concentrate safely, you must still diversify risk. Be aware of the risks that you cannot predict in your upside and downside, then diversify them.
Things like volatility, industry, and factor risks, that are difficult to predict.
I’ve blown up a few trading accounts by doing the opposite and concentrating on risk.
When I shorted VIX futures, I was in effect, taking a concentrated position in volatility risk.
When I concentrated on several SPACs and small-cap stocks, I was taking a concentrated position in small-cap factor risk.
(I’ve made some dumb mistakes that cost me a lot of money!)
I doubled an account when I kept the concentration but diversified the risk.
I picked four information services stocks (IQVia, Transunion, CoStar, FICO) because these business models had great odds and probabilities.
But I diversified based on the industry risk (healthcare, finance, real-estate, credit).
The result? 100% returns in a year (admittedly, that was an exceptional year) without any of the stress of a volatile trading account.
Concentrate on fewer, top-quality stocks.
Get your process down to invest in fewer stocks with better quality and diversify appropriately. You’ll thank me later for the returns.
If you want a free workshop to learn the fundamental process from the Stock Investor Accelerator, just click here.
Important Note:
This is about getting higher returns by picking stocks with a fundamental process.
If you plan to half-ass stock-picking, don’t bother doing any of this. When you have no idea what a stock’s returns can be, you want to diversify to at least 300 stocks, as a rule of thumb.
Index funds will be safer and better for you.
U.S. stocks, International Stocks, and Bonds give you plenty of diversification.
Final note:
This content is for educational purposes only. It should NOT be considered financial advice. I do not know your situation.
References:
Wealth Creation in the U.S. Public Stock Markets 1926 to 2019
Hendrik Bessembinder
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3537838
The Effect of Management Design on the Portfolio Concentration and Performance of Mutual Funds
Eitan Goldman,Zhenzhen Sun &Xiyu (Thomas) Zhou
https://www.tandfonline.com/doi/full/10.2469/faj.v72.n4.9
How Active is Your Fund Manager? A New Measure That Predicts Performance
Martijn Cremers, Antti Petajisto
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719
Decision Trees for Decision-Making
John F. Magee
https://hbr.org/1964/07/decision-trees-for-decision-making
The Diversification Puzzle
Meir Statman
https://www.researchgate.net/publication/228260095_The_Diversification_Puzzle
