Starting can be the most difficult aspect of any endeavor. Bewilderment or intimidation frequently arise from simply not knowing how or where to begin.
Stock investing is no different. There is no shortage of investing options. But the question is, how to combine these options to produce an efficient portfolio – one constructed to generate wealth and income over time.
For years, students of stock-market investing have been inculcated on modern-portfolio theory: The more diversified the portfolio, the less the risk from each individual component. The theory manifests in portfolios composed of hundreds, if not thousands, of issues.
Reduced return is a by-product of excessively diversified portfolios. Sure, you might get the portfolio manager’s best 30 ideas, but you also get 300 of his filler ideas as well. What’s more, these grandly diversified portfolios don’t necessarily reduce risk, if you define risk as volatility, as most investors do.
To reduce volatility, you don’t need to diversify as extensively as you might think. An influential 1968 article written for the Journal of Finance titled “Diversification and the Reduction of Dispersion: An Empirical Analysis” proves the case. The authors showed that as few as 10 to 12 securities can reduce volatility to a level virtually identical to that of the market.
The great investors – Carl Icahn, George Soros, Ian Cummings – understand this concept. They don’t sacrifice return at the altar of diversification. They run concentrated portfolios.
Warren Buffett used to be the master of concentrated investing. Buffett used to run an extremely concentrated stock portfolio for Berkshire Hathaway (NYSE: BRK.a). In the late 1970s and through the late 1980s, Berkshire’s stock portfolio numbered in the single digits. (Berkshire closed 1987 with only three publicly traded issues.)
Economist John Maynard Keynes was one of the earlier practitioners of concentrated investing. “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes,” he reasoned.
From 1924 until his death in 1946, Keynes ran King’s College investment fund. Keynes grew the fund at a 12% compounded annual rate. That might not sound terribly impressive until you consider Keynes’ epoch included a depression and a world war.
Balance, Keynes recognized, is key. You don’t want to overweight an individual security or sector. You want exposure to a range of sectors and investments. Most sectors are imperfectly correlated. When one sector moves, another will move less so, or even in the opposite direction. Combining your best ideas from different sectors reduces volatility and allows you capture superior returns.
We’ve taken this approached and applied it to the High Yield Wealth portfolio. We’ve carved out 12 issues from the 29 that comprise the portfolio. We call this carve-out the “Quick Start” portfolio.
To be clear, we don’t view the recommendations in the “Quick Start” portfolio as necessarily superior to the other recommendations. But when combined, they produce a concentrated high-yield portfolio with significant wealth-producing potential that’s unencumbered with “filler” securities.
The “Quick Start” portfolio will help new investors get started, but it will also help any investor interested in adopting the investment strategies of the great investors.
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