When Diversification Dilutes Returns

Ian Cassel Blog, Educational 4 Comments

In my previous article, Wait For Your Pitch, I outlined the importance of finding your sweet spot and waiting for the right investment. For most experienced investors, your biggest risk is boredom. Extraordinary returns follow extraordinary discipline.

“You have to be like a man standing with a spear next to a stream. Most of the time he’s doing nothing. When a fat juicy salmon swims by, the man spears it. Then he goes back to doing nothing. It may be six months before the next salmon goes by.”
Charlie Munger

A decade ago when I was Getting Started having any cash would result in a pavlovian response. When excess capital is built up by saving or after selling a position the adrenaline starts flowing to find the next one. I would search frantically like a ravenous dog for another company to invest in. There is a certain lure about a new idea, a new potential investment. I would quickly locate several potential investments, conduct due diligence, and add one or two batters to my lineup.

One of the big mistakes I was making was comparing new potential investments against other new potential investments. Instead I should have been comparing these potential investments against my current investments. If you have a baseball lineup full of .320 hitters a .250 hitter won’t help you.

When evaluating a new company it needs to be better than what you already own.

Over the last few years my portfolio hasn’t changed much except for one area. Instead of owning seven positions, I now own five. I sold my two smallest positions aka my lowest conviction positions. This resulted in having some extra cash. After evaluating many potential new investments I came to the conclusion the best investments were already in my portfolio, so I bought more of what I already owned.

I’m a firm believer that whether you are investing $500 or $50 million you need to deploy capital into the best investments you can find. Put another way, you should only own your highest conviction positions. I say this within reason but do not diversify for diversifications sake. Eric Burnside said it best:

Screen Shot 2015-04-20 at 8.08.54 PMIf you have excess cash and the best company at the best valuation is already in your portfolio, own more of it. Position sizing should never have defined or rigid rules. There is nothing wrong with owning more of a great thing.

In Buy Low And Then Buy Higher, I wrote about how all my winners had one thing in common, I was always averaging up. Averaging up hasn’t always come naturally to me. In fact it is counter to human nature. There is something in all of us that makes it hard to add to a position that is materially higher than our original purchase price. It’s the same type of psychological force that drives us to sell our winners to buy more of our losers. William O’Neil, author of How To Make Money In Stocks, calls it the “Price Paid Bias”. Focusing on your initial cost basis causes the mind to do silly things. Whether it’s the urge to sell your winners too soon, or buy more of your losers, investors need to overcome this mental disease and do the opposite. The market doesn’t care what your cost basis is so neither should you. The price you paid for a stock two years ago has nothing to do with what the company is worth today. If a stock is 100% higher than what you originally paid for it, and it’s still a great buy, Buy more of it.

An investor recently asked me the following question:

Question: Imagine a situation where you would be fully invested and the market would throw yet another perfect pitch at you. I know this is a case by case situation but what has your experience taught you? Is it even worth it to consider reducing some of the others to ”bat” this one? Or even, ask a batboy to lend you another bat (read: leverage) to go for it?

Answer: I’d like to premise this by saying my way of investing might not be right for everyone. For me a new potential investment needs to be significantly better (not just incrementally better) than a current position to get me to sell a current position to buy a new position. I like to look at 3 year expected returns, not 1 year. I’m not going to sell a current position that I’m up 500% in that I think has 200% additional upside over the next 36 months to buy a new position that I think has 300% upside in 36 months. It takes months, even years to build conviction in a company. You need to put a value on that trust and conviction. The new position needs to be significantly better. In most cases, the potential return needs to be multiples better. Most reading will think this is insane, but we are talking about buying and holding multi-baggers. I have never gone on margin and would never condone anyone going on margin. Looking back, in almost every circumstance where I’ve been tempted would have ended in disaster. The mindset of spending money you don’t have doesn’t produce good investing decisions.

When evaluating potential investments remember to compare them against the companies you already own. Do not dilute your returns by adding mediocre companies to your stable of great companies. In many cases the best place to deploy new capital is into the great companies you already own.

“If the new thing you are considering purchasing is not better than what you already know is available then it hasn’t met your threshold. This screens out 99% of what you see.”

Charlie Munger

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Comments 4

  1. Good article and it really resonated with me. I only have 4 stocks in my portfolio and it can be maddening at times to see other stocks I thought of owning go up while mine don’t move — that’s just human nature and why successful investing is about managing your emotions. Ultimately, I know that by sticking to my absolute best picks I will have better returns in the long run.

    I think the post you made about the time value that investors put into due diligence in the Xpel thread would have been a terrific quote to include in this article. Here’s the quote:

    “There is a time value that investors put into due diligence and gaining knowledge on a position. The only way to hold multi-baggers is to know them better than most. This is what I call the time value of knowledge. For me to sell a position I like, and most importantly, a position I trust, to buy something new, that new positions needs to be 3-4x the opportunity. Why? Because it just takes time to really know a great company really well.”

    1. Post
      Author

      Thanks Matthew. I’m glad you enjoyed the article and thanks for including that quote from the forums. I do think diversification is important and everyone should own at least a handful of names (~6 +/- 2). Because shit just happens even in great companies, and I fully expect one of my investments will falter and perhaps fail. But I will never add another company beyond that handful unless it’s better then the rest. There is just no point to diluting my returns and my time. I’ve found six companies to be a happy place for me.

  2. Another amazing read, thank you for continuing to share your knowledge and experience with us readers. I am very green to investing and haven’t been doing it for very long but I love the articles posted on this blog and hearing peoples investment experience first hand. I currently own 3 companies and It means the world to get affirmation that my initial thoughts on diversification were correct. Keep up the amazing work on articles and book reviews I will be sure to purchase some of the highly recommended ones.

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