The Danger of Concentrated Portfolios

It was the early 2010s, and your author was confident in his ability to pick winning stocks. So I set upon building a concentrated portfolio.

I took five large positions in what I viewed as great opportunities, including:

• Extendicare (TSX:EXE)

• Pizza Pizza (TSX:PZA)

• Aimia (TSX:AIM)

• Dundee (TSX:DC.a)

• Short Canadian banks (via long-dated options)

Extendicare and Pizza Pizza would’ve been fine, provided I would’ve sold in a year or two when both stocks went higher. But the other three were unmitigated disasters.

Aimia gushed free cash flow, provided it could renew the Aeroplan contract with Air Canada. Everyone knew that — including Air Canada. The airline announced it was bringing its loyalty program in house, and Aimia’s stock got absolutely destroyed.

Dundee was a sum-of-the-parts situation that would’ve been worth something like a 200% gain if all the parts were sold. The two problems with that thesis were a) some of the parts were worth less than $0 and b) management had no intention to sell any of the parts.

Dundee is a big reason why I avoid sum-of-the-parts situations today.

Finally, the Canadian bank short. I was convinced that Canada was in a massive housing bubble and our banks would get hit hard. All of the smart guys on Twitter seemed to agree with me, too. So I used long-dated puts to make a bet against what I viewed to be the riskiest banks — which were basically the banks with the most exposure to Canada.

Fortunately I threw in the towel fairly quickly on that one, and was able to recover a portion of my capital. I’m also firmly of the opinion today that Canada is not in a massive housing bubble.

All I can say about that period of time is thank God most of younger Nelson’s assets were in real estate. I was a so-so (at best) analyst, who was so confident in his abilities that I took irresponsible bets with precious capital — capital that I promptly incinerated.

What did I learn about concentrating?

They say there are no mistakes, but just opportunities to learn. So what did I learn from my experience?

Firstly, I learned the importance of diversification. But more importantly, I realized that capital is precious, and protecting it is the ticket. Diversification lets me easily do that.

Some may argue I take diversification too far (I currently own more than 50 different stocks), but I’d rather overdo it than underdo it. The last thing I want to do is screw up and have it impact my portfolio in a big way. This allows me to keep mistakes small and self inflicted wounds manageable.

But mostly what I learned was a lesson on humility. I wasn’t nearly as smart as what I thought, and I needed a lot more work as an analyst to get my skills where they needed to be.

Ironically, I later realized that diversification is humility. Taking a more diversified approach is admitting you don’t have all the answers, or that you’re not smart enough to outperform using a concentrated portfolio.

I also learned just how devastating suffering a permanent capital loss is. The math doesn’t lie; you have to double your next investment just to break even after a 50% loss. It’s also really hard to compound when you’re starting point is zero.

Let’s strip away all the pithy Buffett sayings and dive deep into what concentrating really is. Running a concentrated portfolio is really a bet on just a few coin flips. Even if the odds are 80/20 in your favour, all it takes is to get unlucky once to permanently impair a big portion of your capital.

Besides, most investors comparing themselves to Buffett is like me comparing myself to Tiger Woods — hey, we both golf, don’t we?

When you have a diverse portfolio, or even a moderately diverse one, getting an investment wrong stings. But it’s not the end of the world. When you concentrate and lose approximately 50% of your investment in one day, that’s potentially life-changing.

I often say I only get one shot at this early retirement thing, and I don’t want to screw it up. So I take a more conservative mindset. We also don’t get very many shots at saving for retirement either.

The concentration paradox

Later on I stumbled upon an interesting paradox, something that I periodically think about even today.

I find that many of the smartest investors I know tend to have concentrated portfolios. They’re good analysts, are confident in their abilities, and are willing to back up that confidence with big bets in stocks they believe in.

Because they’re good analysts, these bets often work out for them.

But here’s the paradox. Just about always these investors get so enamored with the upside they often forget about the downside. This isn’t really their fault, either. It’s almost impossible to fully embrace the negatives of something you’ve put a big chunk of your portfolio into. It becomes more than a stock you own; it’s your identity. You’re the ‘x’ stock guy.

And when something becomes your identity, it’s really hard to pull out, hit the sell button, and admit you made a mistake.

A concentrated bet is really two bets in one. It’s not just a bet on a stock, it’s also a portfolio management bet. The analyst is saying they’re smart enough to not only get this bet right, but the bet is good enough to put a big chunk of their capital into.

I used the word ‘bet’ intentionally in that last paragraph, because that’s exactly what it becomes. And what’s often a good bet at 1% or 2% of your portfolio is an absolutely terrible bet at a 20%, 30%, or even 50%+ weighting. The bet itself isn’t necessarily bad. It’s the portfolio management bet that stinks. It’s a little too much of a good thing.

I’m not immune to making these types of bets, either. I have a small position in Allied Properties REIT (TSX:AP.un), the beleaguered owner of office real estate across major cities in Canada. It has the best office portfolio in the country, the balance sheet is in good shape after it sold off its data centres, and I think the sector continues to recover. Lower interest rates also help, as we’ve seen lately. I liked the setup, so I took a small, somewhat speculative position.

This is a bet on a stock and changing sentiment. And that’s it. By keeping it a small part of a diversified portfolio, I kept that way. It’s not a portfolio bet. If it doesn’t work out I can take a small loss and move on, plus I’ve received some dividends. Taking the L is much easier when it isn’t a big part of your identity, either.

Concentration is all about upside, but I’d argue investing is all about protecting against the downside. Our capital is scarce. For most everyone reading, capital comes from savings, or what’s left over after we trade our time for money. It is a scarce resource and it should not be squandered. But that’s exactly what we risk doing by taking large, concentrated bets.

That is not treating capital like the precious gift it is.

I’m not saying we need to get every investment right. I’ve made tons of mistakes. What I am saying is investors need to avoid really obvious mistakes — like concentrating too much.

The bottom line

Putting 20%… 30%… or 50% of your portfolio into one stock is a risky practice that occasionally ends in tears. We saw that this week as the so-called “fungus barons” lost big time.

The easiest way to avoid such a fate is to not do it. Diversify into multiple companies and asset classes. Getting paid a dividend also helps in such a scenario, since you’re getting capital back each quarter.

But ultimately, my message is this. Concentrating a big chunk of your capital into one or two names isn’t investing. It’s gambling — especially if you’re putting that capital into highly speculative names.

Personally, I stick to investing. And if I do speculate, I limit the exposure to only a small part of my portfolio.

Those following Buffett’s advice on concentrating are forgetting his first rule: don’t lose money. Limiting your downside is at least as important as maximizing your upside, and diversification is probably the easiest way to do so.