The Warren Buffett Spreadsheet – Stock Valuation & Analysis

Charlie Munger and Warren Buffett are famous for advocating a concentrated portfolio of stocks. It seems common among many value investors to suggest that a portfolio of 3-5 quality stocks is enough diversification and also beneficial because you then will have the energy, time and concentration to really understand the companies you are buying.

The reasearch I have read says that any additional stocks above 15 has a very small effect on being more diversified and lessen your risk. I think I read that in The Magic Formula book of Joel Greenblatt.

As you see from the graph the biggest effect of diversification happens up until 10 stocks or so. From there on the effect of adding more stocks to your portfolio has less effect.

The opposite of a concentrated portfolio is an index fund. With these you own several hundreds of stocks and your return will be close to the same as the markets return. With an index fund you are basically betting on a country’s long-term economic performance ( if you for example buy the SP 500 index fund). The downside of owning an index fund is that you both own the good stocks and also the crappy stocks in that index. In addition the index fund is usually market cap weighted, which means that more funds is going into stocks with the highest market caps and then probably also to the stocks that is overvalued. The benefit is that you don’t need to make many decisions and ongoing judgements so there is less chance that your irrational behavior is destroying the returns.

Here is what you seldom hear about diversification:

• A concentrated portfolio can give you the best returns, but can also give you the worst returns. Investing is not about certainties. Nothing is 100% certain in investing. It’s about probabilities and being correct more than you are being wrong over a long time period. Holding only 3-5 stocks makes you very prone to business risk. Can you be really certain that the 3-5 picks that you have made will be performing as you expect? Choosing only 3-5 stocks can be considered overconfidence or it can be brilliance if you really know what you are doing. Investing is a marathon, not a sprint. So if you choose only 3 stocks and 2 of them suffers permanent capital loss, you can be almost wiped out at the beginning of the race. You want to have staying power and be in the game as long as possible and overall do more correct bets than wrong bets. To high concentration can make you prone to unexpected and uncontrollable events that you have little control over.

• A concentrated portfolio can give you a much higher volatility than a more diversified. Are you emotionally able and willing to handle that volatility?

• Even if you hold 10-20 stocks are you actually diversified enough? What about the correlation of the stocks in your portfolio. If you are holding 20 stocks and all of them are in the same industry, a downturn in that industry will drag down all of the stocks in your portfolio at the same time.

My advices for diversification:

• The more experienced and skillful you are as an investor the more concentrated portfolio you can have, and visa versa.
• For the typical value investor I would recommend 10-15 stocks in your portfolio
• Diversify across industries and countries. Use the whole world as a hunting place for stocks.
• Try to select stocks that are not correlated if a downturn happens.
• If you have no experience with investing or are a beginner, consider buying some kind of value weighted index funds. If you want and if you gain more knowledge you can consider slowly adding more individual stocks in the mix.