One of Buffett’s Greatest Tools for Boosting Your Odds of Beating the Market

“Focus investing is a remarkably simple idea,” Robert Hagstrom pens in his book, The Warren Buffett Portfolio.

He goes on to write…

The essence of focus investing can be stated quite simply:

Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations.

Why should you pursue a focused approach? I’ll share the biggest reason today…

I recently had the pleasure of meeting Hagstrom. He’s the author of a handful of popular investing books, mostly having to do with some aspect of the famously successful Warren Buffett’s investing style.

Hagstrom is also a practitioner. He was a fund manager at Legg Mason – along with the celebrated Bill Miller – for many years. And today, he is the chairman of the Investment Management Committee for Stifel Asset Management.

Anyway, I enjoyed meeting him and speaking with him about investing. I read his bestseller, The Warren Buffett Way, when it came out in 1994. I was 22 then. It was one of many books that helped cement my devotion to a Buffett-inspired investment style.

Focus investing is a big part of that style. In The Warren Buffett Way, Hagstrom ran an experiment that shows how focus works…

He used a database of 1,200 companies with reliable data – such as earnings, revenues, and return on equity. He then ran a simulation of 3,000 randomly assembled portfolios, forming four groups:

  • 3,000 portfolios with 250 stocks
  • 3,000 portfolios with 100 stocks
  • 3,000 portfolios with 50 stocks
  • 3,000 portfolios with 15 stocks (the focus-investing group)

And he calculated the returns for each portfolio in each group for a 10-year period ending in 1994…

The pattern here is clear: Having fewer stocks in your portfolio increases your odds of generating a higher return. But it also increases the volatility of that portfolio. In other words, the daily pricing of your portfolio will bounce around more.

He then compared the portfolios to the S&P 500 Index – “the market.” Here are the results (out of 3,000 portfolios per group):

  • The 250-stock portfolios: 63 beat the market
  • The 100-stock portfolios: 337 beat the market
  • The 50-stock portfolios: 549 beat the market
  • The 15-stock portfolios: 808 beat the market

As Hagstrom concludes: “With a 250-stock portfolio, you have a one-in-50 chance of beating the market. With a 15-stock portfolio, your chances increase dramatically, to one in four.”

One in four isn’t exactly great odds – which shows you that focus alone is not a guarantee. And it doesn’t mean you can’t do well with a big portfolio. Instead, owning fewer stocks is a way to raise your odds of beating the market.

When you think about it, this makes intuitive sense… You can only follow so many stocks. You can only really get to know and understand so many businesses. Focus allows you to get the most bang for your buck. When you find a really good idea, you buy a good amount of it.

As Buffett once said, “If I were running $50, $100, $200 million, I would have 80% in five positions, with 25% for the largest.” That’s remarkable focus, more than most investors could withstand.

One other astonishing tidbit from Hagstrom’s experiments: Of the 808 15-stock portfolios that beat the market, 95% of them “endured some prolonged period of underperformance – three, four, five, or even six years out of 10.”

Well, no one said it would be easy.

Nonetheless, these experiments should give you a sense of how portfolio management – specifically, the number of stocks you choose to own – could affect the texture of your results.

To reap the rewards that come from investing this way, you also have to ride out the ups and downs. And you may have to stomach long periods where you will be behind. But in general, you want to own fewer stocks in which you have great conviction… It’s one of Buffett’s greatest tools for boosting your odds of beating the market.

Regards,

Chris Mayer

Source: Daily Wealth