I wanted to share two passages that touch on a recent post, and add some heavy-hitter commentary advocating contrarian thought and concentrated investing. The first is one of Howard Marks’ favorite interview questions (or riddles), which he claims has never been answered correctly:
For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile. What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money? No one has ever answered it right.
The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior. In order to get into the top of the performance distribution, you have to escape from the crowd. There are many ways to try. They include being active in unusual market niches; buying things others haven’t found, don’t like or consider too risky to touch; avoiding market darlings that the crowd thinks can’t lose; engaging in contrarian cycle timing; and concentrating heavily in a small number of things you think will deliver exceptional performance.
The second passage comes from legendary investor Joel Greenblatt’s book You Can be a Stock Market Genius, and adds quantitative support for “concentrating heavily in a small number of things.” Before you read it, I want to point out that the reason for including this excerpt is that many of the methods Marks describes appear counter-intuitive. Why would you invest in what most “consider too risky to touch” or concentrate your portfolio “heavily in a small number of things” when you have always heard to avoid risk and diversify? Greenblatt does an excellent job addressing these questions, and the passage that follows is a good example:
Statistics say that owning just two stocks eliminates 46 percent of the nonmarket risk of owning just one stock. This type of risk is supposedly reduced by 72 percent with a four-stock portfolio, by 81 percent with eight stocks, 93 percent with 16 stocks, 96 percent with 32 stocks, and 99 percent with 500 stocks. Without quibbling over the accuracy of these particular statistics, two things should be remembered:
1. After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and
2. Overall market risk will not be eliminated merely by adding more stocks to your portfolio.
If you are not familiar with Greenblatt I would recommend his book. Not only is he excellent at outperforming the market – he managed an annualized return of 50% over the course of a decade at Gotham Capital – he also has an unusual sense of humor. I like to think it’s why the cover of his book is covered in $100 bills (see image at right).
The letter from which Howard Mark’s riddle was taken can be found HERE.
Title of this post taken from Herb Brooks.