The Warren Buffett Portfolio
Hagstrom on focus investing and running concentrated portfolios.
Summary
Hagstrom's follow-up to The Warren Buffett Way argues for what he calls focus investing, meaning the construction of a concentrated portfolio of ten to fifteen securities held for long periods, and assembles the theoretical and empirical case for it.
His central argument is that diversification beyond a modest number of holdings reduces returns without providing the protection its advocates claim, provided the holdings are selected with genuine analysis. He supports this with simulation work conducted with Joan Lamm-Tennant, which constructed thousands of randomly assembled portfolios of different sizes and found that concentrated portfolios produced both a higher probability of substantially beating the market and a higher probability of substantially underperforming it.
He draws on Buffett, Munger, Keynes, Philip Fisher, Bill Ruane and Lou Simpson, presenting each as a practitioner of concentration, and quotes Keynes' argument that a person's knowledge is limited to a small number of businesses about which they can feel confident. The second half covers the psychology required, arguing that concentration produces higher volatility and longer periods of underperformance, and that the approach fails for anyone who cannot tolerate those. He also covers the mathematics including the Kelly criterion for sizing, and complexity theory applied to markets.
The book's weakness is the same as its argument. Concentration raises the variance of outcomes in both directions, which means the successful concentrated investors cited are a selected sample. Hagstrom addresses this less than it deserves. The simulation results are the most useful part because they state the trade-off numerically rather than rhetorically.
Key takeaways 8
- A concentrated portfolio of ten to fifteen thoroughly analysed holdings can outperform a diversified one for an investor who does the work.
- Concentration raises the probability of substantially beating the market and also the probability of substantially underperforming it.
- Diversification beyond a modest number of holdings reduces returns without providing the protection its advocates claim.
- Turnover should be very low, since the analytical work that justifies a concentrated position is only worth doing for long holding periods.
- Performance should be evaluated over periods of at least three to five years, because shorter periods measure noise.
- Look-through earnings of the underlying businesses, rather than share price movements, are the correct measure of a concentrated portfolio's progress.
- The approach requires tolerating volatility and extended underperformance, and fails for any investor who cannot.
- The successful concentrated investors cited are a selected sample, which the book addresses less than the argument requires.
Who should read it
Investors considering concentration who want the simulation evidence stating the trade-off numerically rather than the usual rhetorical case.
About Robert G. Hagstrom
American portfolio manager who ran Legg Mason's Focus Trust and later served as chief investment strategist at EquityCompass.
The Warren Buffett Way was the first book to reconstruct Buffett's purchases as a repeatable set of business, management, financial and valuation tests, and it set the template later Buffett books follow. Latticework and Investing: The Last Liberal Art carry the same argument into physics, biology and psychology as sources of investment models.
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