The Overlooked Strategy Behind Warren Buffett’s Investing Success

How to Become an Overnight Trader

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The power of concentration. To focus exclusively on the task at hand is an essential variable in success.

It’s also an exceedingly difficult task. Diversions have never been more prevalent, nor have they been more immediate. Thank you, Apple (NASDAQ: AAPL).

Concentration is essential to achieving investment success. It’s more helpful than you realize. Concentrate your thoughts, by all means, but also concentrate your investment portfolio.

If you vet the investing strategies of the great investors, you’ll unearth a plethora of category preferences. Some great investors prefer value, others growth. One investor’s portfolio might comprise big-cap stocks, while another might comprise small caps.

You might even stumble upon an investing menagerie that defies categorization.

The affinity for a specific stock category might vary, but whatever the category, you’ll frequently find that the category is limited in diversification by number.

Berkshire Hathaway (NYSE: BRK.b) of 2018 is a sprawling, multi-billion-dollar conglomerate. It claims full or partial ownership interest in over 90 companies. Berkshire’s stock portfolio comprises 45 different issues (and the number excludes any foreign positions).

You could argue that Berkshire is too diversified.

I’ll concede that Berkshire has a long history of outpacing its benchmark – the S&P 500. Most of the outpacing, though, occurred in the more-distant past. Until Warren Buffett announced in July that he was willing to buy back Berkshire’s shares on more liberal terms, Berkshire’s share price had actually lagged the S&P 500 in recent years.

Buffett generated his most breathtaking returns when Berkshire ran on a concentrated stock portfolio.

Through most of the 1980s, Berkshire’s common stock portfolio rarely exceeded 10 issues. In one year, 1987, Berkshire owned as few as three issues. Six to eight was the norm.

Buffett’s reputation as an investing genius bloomed over the 1980s, as Berkshire’s shares appreciated at a 42% average annual rate. The S&P 500 was left hopelessly waving away the dust. It appreciated at an 11% average rate over the same period.

Buffett no longer practices concentrated investing, but many successful investors still do.

Carl Icahn has 72% of his portfolio concentrated in only five issues. Bruce Berkowitz of Fairholme Capital Management owns only 13 issues. One issue, St. Joe Corp. (NYSE: JOE), accounts for 68% of Fairholme’s portfolio value. Lou Simpson of SQ Advisors owns 15 issues. Bill Ackman of Pershing Square Capital owns eight issues.

Charlie Munger, Warren Buffett’s nonagenarian partner at Berkshire Hathaway, runs a four-stock portfolio at the Daily Journal.

Holding so few stocks appears risky. It’s less risky if we differentiate risk from volatility.

Bill Ackman captured headlines a couple years ago with his infamous Valeant Pharmaceuticals (NYSE: VRX) investment. Valeant result in a $3 billion loss. Keep in mind, though, from 2004 through 2014, Pershing Square generated a 692% total return net of fees. When we take the long view, we find Ackman is still deep in the black.

The good news is that a concentrated portfolio is less risky than you might think.

An influential 1968 article written for the Journal of Finance  – “Diversification and the Reduction of Dispersion: An Empirical Analysis” – proves it so. The article’s author found that as few as 10 issues can reduce risk to a level virtually identical to that of the market.

The authors found that gains to diversification are strongest up to five stocks. When a portfolio reaches 10 to 15 stocks, maximum benefits are achieved. After that, the curve levels and risk-reduction gains are minimal.

The problem for individual investors is how to construct a concentrated portfolio. Fifteen gold-mining penny stocks will hardly do. For that matter, 15 of the world’s largest energy stocks won’t do either.

Balance is key: If possible, opposed the perceived risk. Consider pairing stocks, such as an airline stock with an oil stock, or a consumer product stock with a tech stock.

Yes, a portfolio of 12 to 15 stocks will be more (but not necessarily much more) volatile than a portfolio of 150 stocks. The good news is that the 12 to 15 stock portfolio will offer something beyond the capability of the 150-stock portfolio: The potential to generate index-beating wealth over time.

So, by all means, maintain your concentration. And if you’re able to endure a little more volatility, extend your concentration to the number of investments in your portfolio.

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Published by Wyatt Investment Research at