Stock pickers will lose battles, but may win the war

Successful stock pickers are a rarefied breed. They’re idolized and celebrated. But how do you spot them? Or more importantly, what traits can you emulate to become a better stock picker yourself? Here’s a clue: when it comes to investing, they don’t mind losing the battles, confident they will win the war. And when they do, the results can be amazing. Recently, I was lucky enough to hear a talk by value investment manager and author Michael van Biema at the Toronto Value Investment Conference. His book, Concentrated Investing: Strategies of the World’s Greatest Value Investors goes into great detail on how the strategies of some of the most successful investment legends have achieved phenomenal double-digit average annual returns over the long run. I highly recommend to any active stock pickers eager to learn from the greats. At the start of the book van Biema, the founder and chief investment officer of van Biema Value Partners, a value-focused fund of hedge funds based in New York City, reveals how a light went off when he realized that the investors he admired most shared one characteristic: they were concentrated value investors. Rather than hold an ETF, which mirrors an index that can contain hundreds of companies, a concentrated portfolio would hold only a small number of securities (sometimes as few as two or three). They are the antithesis of a diversified portfolio.

Put your eggs in one basket

Next time you flip through the Forbes wealthiest people list, note how much of their wealth comes from one or two companies. You’ll find household names like Bill Gates and Warren Buffett who have been spectacularly rewarded for putting all their eggs in one or a few baskets. Still, I can’t shake the feeling that this approach works better in theory. If you know exactly which stocks will offer the best returns, it makes total sense to bet only on a few that will give you the biggest bang for your buck over time. Unfortunately, the real world is veiled in uncertainty and sometimes the safest-looking stocks turn out to be duds. Such randomness can inflict serious damage to under-diversified portfolios.

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So how many stocks should you own to be sufficiently diversified yet properly placed for maximum long-term profits? Well, according to van Biema, as well as other concentrated value investors and surveys done on the topic, the magic number is 20 to 30 stocks.

How concentrated is too concentrated?

Not everyone agrees. Hedge fund manager and contrarian investor Boris Marjanovic says he prefers to use the 1/N rule when deciding on the right number of stocks to hold because it takes into account investors’ subjective risk tolerances. “The denominator ‘N’ is the maximum percentage of your equally-weighted portfolio that you can afford to lose if one of your stocks goes bankrupt,” wrote Marjanovic in a recent online article. “For the typical investor, it’s about 5%—the equivalent of owning 1/0.05 = 20 stocks. If you happened to be a more conservative investor, it might be 1% or even lower, in which case you should own at least 1/0.01 = 100 stocks.” And while concentrated investor Warren Buffett has said, “diversification is protection against ignorance…that those who know what they do concentrate their bets,” the truth is, most of us don’t have the time, resources or temperament to invest in such a concentrated way. Buffett also notes in his latest letter to Berkshire Hathaway shareholders that for smaller investors avoiding high unnecessary fees and buying a good ETF index fund from a company like Vanguard is a great option for solid returns. Even active fund managers struggle with this. Study after study has shown that only in five active mutual fund managers of large-cap stocks portfolios will outperform the market.

Most investors are better off pursuing a passive strategy

Few individual investors lack of time, patience or the right demeanor to invest individual stocks is one major reason why many investors are better off pursuing a passive investing strategy. But if what you’re looking for is to simply learn more about this strategy van Biema’s Concentrated Investing is a fascinating 650-page read into the adventures and strategies of stock pickers who invest in just this way.

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That includes profiles of math professor, hedge fund manager and black jack player Edward Thorp. To beat roulette, Thorp invented new applications of probability theory and even wrote best-selling book Beat the Dealer—the first book to mathematically prove that the house advantage in blackjack could be overcome by card counting. Van Biema’s book also includes a lengthy chapter on Lou Simpson, a former GEICO investment manager and eventual successor to Warren Buffett at Berkshire Hathaway, who is famous for saying, “The stock market is like the weather in that if you don’t like the current conditions all you have to do is wait awhile.” The bottom line: If you don’t have the time, patience or resources to find hidden gems like these phenomenal concentrated value investors, stick to a passive, well-diversified portfolio. This approach will give you good-enough returns over a lifetime to likely keep you very comfortable. The truth is it requires a lot of hard work and a significant amount of knowledge—and of course, the right temperament—to produce market beating returns. If you do not have this, it is to your benefit to diversify and happily remain a passive index investor.

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