The financial world preaches diversification because it’s safe and comfortable, but often times to learn and excel you need to be uncomfortable. The point I’m making isn’t that concentrating is better than diversifying as an investment strategy. Investors can succeed utilizing any strategy. But I do believe that concentrating is a great way to learn investing. When you concentrate on a few positions your successes and mistakes are amplified, and you learn the hard lessons faster. The real educator in investing is making and losing real money. 95% of successful investing is controlling your emotions when your own money is on the line
When I was in college I took a course on “Early American Literature”, and the class focused on literature written pre-1900. The teacher was an energetic, opinionated, and intimidating African-American woman. I remember one day we were preparing to read a book on the slave trade and specifically the “Middle Passage” where at least 2 million African Americans were taken from West Africa and shipped across the Atlantic Ocean. These slave ships were overcrowded, and the conditions were inhuman. It is said that roughly 40-50% of slaves actually made it alive to their final destination in the United States or elsewhere.
In preparation for reading two books on the Middle Passage, she taped off a rectangular area 6 feet by 12 feet in the front of the classroom. She then had all of us, 40-50 students, stand in this area. She maneuvered us into position. We couldn’t move because we were so cramped together. She then told several students to do things such as:
“Mike, I want you to start coughing because your sick [playing sick]. And don’t turn your head because you can’t. Cough into the person in front of you. Amanda, you have a stomach illness and you are vomiting on people all around you [making heaving noises]. Brad, you are going to go to the bathroom right where you stand. John, you have two others leaning on you because they are so weak, and you too are about to fall to the ground under their weight.”
The teacher did this for a few more minutes setting the stage.
She then said, “It’s also 110 degrees and everyone is sweating. Can’t you smell the odors? See the pain? Hear the cries and moans? Can you think of an environment much worse than this? Probably not. We are faking this scene in an air-conditioned classroom for only a few minutes. When you read these books I want you to imagine being on one of those ships for weeks.”
We all breathed a sigh of relief when we sat down, but the exercise made its impression. It was uncomfortable. It was in your face. It was violent. There was no escaping it. When we read the two books on the Middle Passage we probably absorbed five times the amount of information because of that exercise. I can still remember to this day standing in the front of that room cramped together not being able to move.
Financial pundits don’t like volatility. They don’t like uncomfortable. They don’t like deviating from the status quo. They like S&P 500 ETFs. They would rather preach diversification and teach you how to apply every backward looking financial metric, ratio, etc they can find on a stock in hopes of paralyzing you into never buying anything but an ETF [sarcasm, sort of]. It’s hard for many to embrace the fact that concentrating on a few stocks is a far better educator than trying to learn everything about every stock.
When I started out as an investor and aspiring to be a stock picker, I only had a small amount of capital. What’s the point of investing a small amount of capital across a plethora of companies? Not much. When you are learning how to pick stocks, holding a few positions is adequate so you can truly focus on the nuances of those businesses.
When you are concentrated in a few positions, the education of doing so can be violent and uncomfortable. The monetary ramifications of your decisions are amplified. Your emotions are amplified. But this also allows you to absorb and learn the hard lessons faster.
“Extreme outcomes — good or bad — often educate best.”
– Charlie Munger
You won’t find many people preaching concentrating on a few stocks as a superior form of learning investing. Because no one wants to endorse anything that is uncomfortable or that could hurt someone. But it’s those violent lessons that teach you the most. The irony of it all is that most wealthy people that preach and teach diversification today built their wealth by concentrating heavily on a few ideas early in their life.
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