Thursday, April 27, 2006

Portfolio Construction - Outperformance

If you want to outperform the market, to build a better portfolio, then you have to be willing to do things differently than most of the herd.

First among these is committing to your positions. Today, this is called a "focused" portfolio or if a mutual fund does it, a "focused fund". Recent academic studies have shown that focused funds perform, on average, a couple of percentage points better than the typical fund. This is no surprise really, since you are willing to commit more capital to those positions holding the best promise.

While some diversification has it's place, too much will produce only market performance at best. Think of it like a game of Texas hold 'em poker: If you got dealt two aces "in the hole" to start the game, would you start off with an average-sized bet? If you did, you'd be wasting your huge advantage.

Investing is like that too: you should commit larger amounts of capital to the most promising positions, and less to the ones which are still promising, just less so.

I personally think that no one who wants outperformance should have more than 25 positions, and that the minimum amount of any position should be at least 4% of the portfolio value. Without being willing to commit at least 4% of your capital to a position, shows a lack of confidence in it, perhaps underpinned by a lack of understanding of it, its industry, etc. In that case, you shouldn't invest at all.

In some exceptional cases, you might want to commit 20% or more of your capital to an exceptionally promising situation. Superinvestor Warren Buffett has remarked that early in his career he held over 50% of his net worth in a single stock, and slept like a baby every night (presumably because he felt the stock was remarkably under-valued).

You need to ask yourself a few questions before your undertake your purchase - before deciding on the percentage of your portfolio you're going to commit to it:
  1. What are the odds that something could go wrong with this stock, and
  2. If something goes wrong, how much damage will it do, and
  3. If things go as I foresee, how much upside does this add to my portfolio?

When you can answer these questions to your satisfaction, then you'll have an idea how much capital to commit. Never forget to build a "margin of safety" into all your estimates.

Thinking differently: the first step to outperformance.



JW

The Confused Capitalist

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2 comments:

The Dividend Guy said...

Hey, good post. I have been thinking a lot about this lately. The problem I run into is emotion - it is easy in this type of market to be quite fond of a focused approach. The real test is when the broader market is tanking and so are your focused positions. Being more diversified can help in these situations as it reduced those wild swings which can be hard on the stomach.

Jay Walker said...

Thanks.

Yes, emotionally you have to be up to it, and have confidence in your positions. Otherwise, you'll just be another underperforming investor.

Jay Walker