The strategy of concentrated investment.

Although concentrated investment is a simple idea, it is rooted in a set of complex and interrelated concepts. This idea runs counter to conventional thinking methods. The essence of concentrated investment can be briefly summarized as follows: choose a few stocks that can generate higher-than-average returns in long-term tug-of-wars, concentrate most of your capital on these stocks, and hold them firmly to win steadily.

Concentrated investment was born against the background of the popularity of active investment and index investment. Active investment frequently buys and sells, constantly changing investment portfolios, hoping to profit from predictions. Index investment collects and holds various common stocks and creatively designs investment portfolios that closely track the S&P 500 index. Buffet appreciates index investment, believing that it is most suitable for novice investors, but he has opened up a third option, the concentrated investment strategy. The core of concentrated investment is to concentrate your investment on the few companies that are most likely to produce higher-than-average performance.

Buffet's concentrated investment strategy is inspired by the great economist John Menard Keynes and the 'Father of Growth Stocks' Philip Fisher. Keynes once said that he was confident in only two or three companies he invested in. Fisher restricted his capital to fewer than ten companies, with 75% of his investments focused on three or four companies. They always prefer to invest in a few outstanding companies they know very well rather than numerous companies they do not understand. They believe that buying stocks in companies they do not understand may be much more dangerous than not being sufficiently diversified. Especially Fisher, his influence on Buffet was huge. Fisher firmly believes that when encountering excellent opportunities that are within reach but not within grasp, the only rational way is to invest heavily. Moreover, the best stocks are always very difficult to find, and once found, they must be focused on investment. This means that 'less is more'. In response, Buffet actively advocated: for every investment you make, you should have the courage and confidence to invest more than 10% of your net assets in this stock. When Buffet bought American Express in 1963, he invested $13 million, 40% of the company's assets, in this excellent stock, which accounted for 5% of the company's stock at that time. In the next two years, the American Express stock tripled and the partnership company in which Buffet belonged earned a profit of $20 million.

Fisher, in particular, had a huge influence on Buffett. Fisher firmly believed that when encountering excellent opportunities that were within reach, the only rational thing to do was to invest heavily. And the best stocks are always very difficult to find. Once found, they must be invested in extensively. This means "less is more."

Buffett responded positively to this: For every investment you make, you should have the courage and confidence to invest more than 10 percent of your net assets in this stock. When Buffett purchased American Express in 1963, he invested $13 million, or 40 percent of the company's assets, in this excellent stock, accounting for 5 percent of American Express's shares at the time. In the following two years, American Express's stock tripled, and the partnership with Buffett made a profit of $20 million.

Concentrated investment seeks returns higher than the average level. From academic research and practical case analysis, there is ample evidence that the pursuit of concentrated investment is successful. However, on the journey of pursuit, it is full of bumps, and concentrated investors must endure this turbulence, because they know that in the long run, the economic benefits of the companies they hold will compensate for any short-term price fluctuations. Charlie Munger's view is consistent with Buffet's: 'As early as the 1960s, I actually rely on compound interest tables to make various assumptions about the performance of common stocks to find out what advantages I can have.' His conclusion was that owning three stocks is enough as long as you can withstand price fluctuations.

Concentrated investment seeks returns higher than the average level. There is ample evidence from both academic research and practical case analysis that concentrated investment is successful. However, on the journey of pursuing this strategy is full of bumps, concentrated investors must endure this bumpiness because they know that the economic benefits of the companies they hold will compensate for any short-term price fluctuations in the long run. Charlie Munger agrees with Buffett's view: "as early as the 1960s, I actually referred to a compound interest table and made various hypothetical analyses of the performance of common stocks to find out what advantages I could have." His conclusion was that having three stocks is sufficient as long as you can withstand price fluctuations.

Concentrated investment is a simple concept that draws on the essence of logic, mathematics, and psychology that are related to each other. Using Buffett's investment strategy, choose several companies that have had higher investment returns than the general level in the past and bet most of the funds on the stocks with the highest probability. As long as things don't get too bad, keep the equity intact for at least 5 years, and exceed it better.

To Hagstron, concentrated investment is defined as a "culture" that is built on several patterns of "narrow culture". These patterns include behavioral patterns in psychology, probability theory in statistics, and the principle of complex adaptation. By combining these principles and using them for the same purpose, it is called "grid thinking". When Buffett summarized the experience accumulated by Berkshire Hathaway, he described his company as an "educational company that teaches people the correct way of thinking through the practical application of some important concepts". It contains eternal truths: basic common sense, basic fear, and basic human analysis, which allow them to predict human behavior. If you can do the above and follow some basic principles, you will do well in investment.

Experimental effectiveness of concentrated investment.

To verify the effectiveness of concentrated investment, Hagstron used a computer statistical database of common stock investment returns, separated 1,200 companies that showed measurable data, including total revenue, net earnings, and return on assets. The deadline for obtaining data is from 1979 to 1986. Let the computer randomly combine to form 12,000 investment portfolios of different sizes from these 1,200 companies. Then, calculate the average annual return rate of each type of investment portfolio and calculate it according to 10 and 18 years. Compare the returns of the four different investment portfolios with the same period of the S&P 500 index, and draw a key conclusion: in any case, reducing the number of stocks in the investment portfolio will increase the possibility of obtaining higher returns than the market.

Then, calculate the average annual return rate of each type of investment portfolio and calculate it according to 10 and 18 years. Compare the returns of the four different investment portfolios with the same period of the S&P 500 index, and draw a key conclusion: in any case, reducing the number of stocks in the investment portfolio will increase the possibility of obtaining higher returns than the market.

When observing the minimum number of stock groups/maximum number of stock groups-the worst and best performance in each group, it can be found:

The same trend was found in the long-term (i.e., 18-year period). Portfolios with a small number of securities produced higher or lower returns than portfolios with a large number of securities. These results lead to two important conclusions:

First, by having a concentrated investment portfolio, you will have a greater chance of beating the market;

Second, by having a concentrated investment portfolio, you will have a greater chance of losing to the market.

To deepen the impact of the first conclusion on skeptics, Hagstron found that there are some important statistical conclusions in 10-year data:

The fourth conclusion is strong evidence that reducing the number of securities owned increases the likelihood of beating the market.

Owning 15 stocks increases the odds of beating the market by 4:1; owning 250 stocks increases the odds of beating the market by 50:1.

However, even though they try to implement a concentrated investment strategy, super investors have all experienced periods of poor short-term performance. John Maynard Keynes’ performance was below the market average for 1/3 of the 18 years he operated the Chester Fund. In the first three years he oversaw the Fund, his performance was 18 percentage points lower than the market performance. Ruane's Sequoia Fund had performance below the S&P 500 index for four consecutive years in the 1970s. In 1974, the Sequoia Fund fell behind the market by 36 percentage points. Munger's partnership has a 36% loss rate during his 16-year tenure, including a 37% market lag from 1972 to 1974. Four of Simpson's 17 years as head of the Government Employment Insurance Company saw below-market performance, accounting for 24% of total years. In the short term, their performance was indeed bad.

Holding time needs to be long enough.

The super investors listed by Buffett, such as John Maynard Keynes, Warren Buffett, Charlie Munger, Bill Ruane, and Lou Simpson, all basically adopt a concentrated investment strategy. They all revolve around those who have long-term sustained market-beating performance, who do not rely on luck, but rely on following the basic principles established by one person, Benjamin Graham.

They have a common strategy that is closely related, which is to fully utilize the difference between the market price of the company and its intrinsic value.

They focus on a few rare good stocks and build the investment portfolio around these choices, and the selling price of these stocks is much lower than the estimated market value. Their common belief is that the way to reduce risk is to buy stocks with high safety margins.

However, even if they try to practice a concentrated investment strategy, the super investors have also experienced periods of short-term performance declines. In the 18 years that John Maynard Keynes managed the Chester Fund, one-third of the time was below average market performance, and in the first three years he managed the fund, his performance was 18 percentage points lower than the market performance.

Bill Ruane's Sequoia Fund suffered from lower-than-S&P 500 performance for four consecutive years in the 1970s. In 1974, Sequoia Fund fell behind the market by 36 percentage points. Charlie Munger lost money in 36% of the time he managed his partnership company and fell behind the market by a full 37 percentage points from 1972 to 1974.

Lou Simpson had four years of below-market performance in the 17 years he managed the Geico Insurance Company, accounting for 24 percent of the total years. In the short term, their performance was indeed bad.

Hagströmer used the data of several groups of 1,200 companies established in the laboratory to see the relationship between enterprise earnings and stock prices at different stages. When deciding the degree of correlation between enterprise earnings and stock prices, Hagströmer found that the longer the time, the greater the correlation:

This confirms Buffett's point that if the time is long enough, a company with good performance will inevitably produce strong stocks. Although over time, the correlation between earnings and stock prices has become increasingly greater, it is not always predictable. As Buffett said, from a long-term perspective, market value and enterprise value are advancing in parallel, but the relationship between them in a single year may be mysterious.

Benjamin Graham pointed out long ago: "As long as the intrinsic value of a company grows at a satisfactory rate, it doesn't matter if it is recognized by others at the same rate of its success. In fact, it's a good thing that others recognize its success later, because it gives us the opportunity to buy high-quality stocks at lower prices."

Concentrated investment must be a long-term investment. Buffett's ideal holding period is "forever" - as long as the company continues to generate above-average economic performance, and the management can rationally allocate the company's profits, this stock is worth continuing to hold. Buffett warns us that if you own a poor quality company, you should sell it so that you can own better companies in the long run; but if you own an excellent company, don't sell it.

The investment management strategy that acts like a tree sloth not only increases capital above average, but also has two other economic benefits:

A study showed that as long as the turnover ratio reaches 25%, 80% of the taxes generated by securities investment is equivalent to the taxes generated by a turnover ratio of 100%. The conclusion is that when you invest in securities with a low turnover ratio, you should pay considerable attention to it, rather than only paying attention when the turnover ratio is very high.

In order to maintain a high after-tax rate of return, investors must keep their annual average investment turnover ratio between 0% and 20%.

What strategy helps maintain a low turnover ratio? One practical method is an index fund strategy, and the other is a concentrated investment strategy. A low turnover ratio means low transaction costs, while a concentrated investment strategy gives you the greatest opportunity to compound unrealized capital profits into appreciation profits.

Bet big when you have the advantage.

The Kelly criterion, named after John Kelly, a scientist at Bell Labs, states that the greater the advantage, the greater the amount of the bet; if there is no advantage, then it is not worth betting. If we follow the Kelly criterion, we will never play games without an advantage, like slot machines or roulette.

In any case, bets should be made based on a certain percentage of the total capital. If we lose continuously and our total capital decreases, we should reduce the betting amount accordingly.

As long as we follow the Kelly criterion, we are unlikely to go bankrupt. Charlie Munger greatly appreciates this: 'When the world presents the opportunity, smart investors bet big. They bet big when they have the advantage, but they don’t do that at other times. It’s that simple.'

Seth Klarman, a famous value investor, believes that to reduce portfolio risk to an acceptable level, you do not need to hold too many stocks. Usually, holding 10 to 15 stocks is enough.

Graham proposed the concept of limited diversification. The minimum combination should include 10 stocks, and the maximum should include 30. Buffett said that if he manages $50 million, $100 million, or $200 million, he will diversify 80% of his funds into 5 stocks and put 25% of his funds into the stock being rebalanced.

The reason for the need to concentrate investments is directly related to the power law distribution. According to this law, a small number of companies will outperform all other companies. A good investment portfolio must have the real possibility of achieving great success in each company.

According to the power law distribution, the most unique companies are the ones that are truly one-of-a-kind, and one company will outperform all other companies. Therefore, it is not necessary to hold too many company stocks. Just three to five companies are enough. The more diversified the investment portfolio is, the more it tends towards the average market return.

By concentrating investments heavily on a few companies that meet investment criteria, as long as the risk-return ratio is in our favor, we can wisely take on risks and have the opportunity to obtain high returns.

Munger is an advocate of concentrated investment. In his own stock asset account, he only has three stocks with a total market value of more than $2 billion. Munger believes that the probability of failure for one of these is almost zero, and the probability of failure for all three is almost zero.

Diversified investment is for people who don't know anything - according to the definition, they can only get average returns. Diversified investment will only make you spread too thin, so it's better to concentrate your efforts and focus on a few high-quality companies in order to achieve great profits on the road of wealth creation.

Think about three basic principles.

Buffett's investment strategy has remained almost unchanged for a long time. He always considers choosing companies, management conditions of companies, financial performance, and current market prices in order. With this, he developed three basic principles that he has always been thinking about.

Concentrated investment and long-term investment are not easy and difficult to achieve. Therefore, Haggstrom suggests that the books "Buffett's Way" and "Buffett's Investment Portfolio" be put together as a guide for investors. If we are ready to fasten the seatbelt of concentrated investment, Haggstrom offers us the following advice:

As a concentrated investor, our goal is to know more about our company than all Wall Street investors. If we are willing to work hard and learn as much as possible about our company, we are likely to know more about it than the average investor, and this is all we need to gain a competitive advantage.

Winners have their own strategies. Buffett once said that his investment strategy is not beyond the understanding of serious investors. But it does take time to study. "Investing is easier than you think, but harder than it looks." Successful investors don't need to learn high-level mathematics full of Greek symbols, learn to decode derivative tools, understand the fluctuations of international currencies, and certainly don't need to understand the policy of the Federal Reserve. Of course, they don't need to follow the daily cliché of market trend forecasters.

Edited by Jeffrey