Warning: this isn’t financial advice, just my own thoughts.
Concentration is demonized as risky. While this is true for some, I think the common personal finance advice is off the mark for some. Specifically, if you are someone like me who wants to be a long term investor (business owner), being overly diversified (especially in the beginning) makes very little sense on a few fronts.
Holding a large number of stocks means that you might as well just own an index and dollar cost average your savings over time. The generic advice that this is the best strategy is true for most.
You cannot understand and follow a large number of businesses. How could one person possibly know 100 diverse businesses well enough to be comfortable as a long term owner?
If you are an individual with a reasonably steady and reliable income (most individual investors don’t do it full time at the beginning), then starting out with just a couple stocks means that you can diversify over time with very little risk.
Someone with reliable and likely growing income that can save a good amount of it to invest over time has a distinct advantage over a portfolio manager with a fixed amount of capital and incentives to not go through stretches of underperformance. The young individual that is able to save say ten grand a year to invest can likely do the same each year for the next decade. If they start at 20 or 25 then before they are 40 they can build a well diversified portfolio of 30 businesses by simply working hard each year to find one or two good ideas to invest. This results in the potential to have a diverse portfolio of (hopefully) great businesses (some bought at great prices) over time. By the time you are 40, you should have a few great winners and likely a few losers but you will have committed a reasonable stake into each and every business in your portfolio.
If you counter this with someone who starts out by buying 30 stocks to build a portfolio from scratch results in making small bets into 30 ideas. How many great investors can find that many great ideas at any given time? Now how many rookies can possibly do that? It likely ends up making a very mediocre portfolio with a few good ideas at VERY small weights.
One could argue that you could average up into your winners over time and cut your losers. While this is theoretically true and most people AGREE that this would be a great strategy, most aren’t able to do it. Its too hard to psychology convince yourself to do this.
The other benefit of buying a couple of your best ideas each year is that it forces you to learn a lot about a few good ideas and have more conviction. Allows you to make more meaningful capital allocation and to think as a business owner instead of a collector of stocks. Conviction is crucial to have the patience in the business to be able to hold through the rough patches that all great businesses will go though.
The other indication that this strategy could be a good one is that it aligns with Warren Buffett’s punch card advice to young investors.
I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”
Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.
W.E.Buffett
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