The Compound and Friends - Best Ideas portfolio (with Josh and Michael)

Episode Date: April 5, 2019

In a recent study, Vanguard took a look at the last 30 years worth of data for the Russell 3000 index, which represents the total stock market. They found something remarkable - over the last 30 years, 47% of stocks were unprofitable investments and almost 30% lost more than half their value. They also found, and this is the big one, that 7% of stocks had cumulative returns over 1,000%. But imagine how hard it would have been to identify that winning 7% and concentrate only on those holdings in advance? In his recent post, Michael Batnick takes Vanguard's data and looks at the long-term risk of trying to only hold a small amount of stocks, even if you have the conviction that they are the right stocks. Diversification has a much better track record than randomized collections of larger positions.  What are the ramifications of this for portfolio construction? How about investment advice? Michael and Downtown Josh Brown sort it all out in a brand new Live from the Compound. Read Michael's post here and see the charts for yourself:  https://theirrelevantinvestor.com/2019/03/25/how-concentration-affects-portfolio-performance/ Enable our Alexa skill here - "Alexa, play the Compound show!" https://www.amazon.com/Ritholtz-Wealth-Management-LLC-Compound/dp/B07P777QBZ Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/ Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer if you seriously need this spelled out for you.  https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi, I'm Josh Brown. Welcome to Live from the Compound. Are you, like most people, under the impression that it's easy to pick stocks, outperform the market if you just get the right companies and own enough of them and hold on for long enough? Who's schtick is this? Why can't I just... And... Listen, I'm here with Michael Batnick. We're going to talk about concentrated portfolios, the agony and the ecstasy of concentrated portfolios. And I think you're going to learn a couple of really important things. Mike, yourasy of concentrated portfolios. And I think you're going to learn a couple of really important things.

Mike, your post about concentrated portfolios, you're looking at this idea that you can just focus on buying the best stocks, the highest quality stocks, and potentially, if you give it a long enough period of time, outperform the index. But the work that you're referencing actually shows the opposite. And the more stocks you own, the more of a chance you have to beat the index. Doesn't that seem counterintuitive? Yeah, maybe. Well, let me tell you this. Stanley Druckenmiller, one of the, if not the greatest money manager of all time, said, I think diversification and all the stuff they're teaching at business school today is probably the most misguided concept everywhere.

Diversification is misguided. The first thing I heard when I got in the business was bulls make money, bears make money, and pigs get slaughtered. I'm here to tell you I was a pig, blah, blah, blah. Okay. So I think that that quote is used all the time. Right. Oh, the pigs get slaughtered? And just why diversification is bunk and how Drucker Miller,

you know, the greatest, didn't believe in it. But why is diversification being a pig? I don't understand. I don't understand the connection. He's basically saying like, wow, if you have your best ideas, you got to go for it.

If you have your best ideas, you should only own those. Why would you own your 21st best stock? I mean, it's the sort of thing that like sounds obvious and makes it sound so easy. Like, well, but that, that, that implies that your best ideas could actually work.

No, that implies that you actually know what your best ideas are. Right. Like that implies that today in 2019, you know, with any degree of certainty that in 2029, yeah, these were the stocks I should have concentrated on. How could you possibly? So what are your three best index fund ideas right now? So what this study did was it basically quantified dart throwing for stock picking. Okay. So explain that. So when you have a portfolio of 30 stocks, the chart that we're going to pop here is showing that over a 30-year period of time, and they randomized all these portfolios? I don't know if it was 30-year rolling periods, but this was totally random. They did like a thousand simulations. It's in the post, which we'll link to in the notes.

So simulations of different amounts of stocks in different arrays. And then what was your probability of beating the S&P by holding 30 stocks or 50 stocks? It was Russell 3000. Russell 3000. But so it went up. I don't know if I'm using monotonically here, but I hear it said a lot. Right. Monotonically? Yeah. Go ahead.

So it went up like linearly, I guess, is a better... The more stocks, the higher the likelihood. Yeah. So at five stocks in the portfolio, you had just a 28% chance, a 29% chance. Yeah. So at five stocks in the portfolio, you had just a 28% chance, a 29% chance. At 10, it was 35. At 15, it was 37. And it plateaued at 500. Or even if you picked 500 random stocks, you had a 48.4% chance of beating the market. But the problem is that that just tells you the probability of outperforming. It doesn't tell you the magnitude of underperformance or outperformance. Oh, the skew. Yeah. So if you just pick one stock at random, the negative skew is like totally

dominated. So one stock on average, if you underperformed, you underperformed the benchmark by 11.7%. If you outperformed, you outperformed by 4.2%. So your odds of winning big are way smaller than the chances that you're going to lose big. I guess beef is the wrong word, but here's the other side of this article that they don't show. So they're saying that because the winners are so concentrated, because only 7% of stocks had 1,000% performance. So let's – before you say what you're going to say, let's just explain that. Of all the stocks they looked at in the Russell 3000 over 30 years, only 7% of those stocks managed to earn a return of a thousand percent or more. Now, hold on. Somebody- Which is what you would have needed to offset.

Correct. Are the losers. So somebody actually, and this kind of makes sense. I don't know if the thousand percent was over a 30 year period, like start to end. Or period during the period. Because how many stocks had a thousand percent run- And then gave it up. And might have only like a 300%, you know what I mean?

I would imagine it happens a lot. So that probably it bigger but anyhow the point is that and there's been a lot of work on this that if you miss the very big winners microsoft apple etc uh you're basically shit out of luck and on the other side of that you say 30 of stocks lost at least half of their all right so so there's more big losers than there are big winners. 7% huge winners, 30% huge losers. Right. So what if there was a way to hold a large diversified portfolio and screen out the losers? Now, obviously, maybe that's easier said than done, but I'm sure that there's certain quantifiable characteristics that you can do to determine what stock is likely to have a portfolio. You can throw some screens on that list.

Like just for instance, you were saying companies growing earnings. So companies that have a price to earnings ratio, something very simple, three standard deviations higher than normal with slowing earnings growth. As a screen out. Yeah, or cheap stocks with growing accruals or maybe accounting irregularities or cheap stocks trading below the 200 day. I mean there's a million things that you could do. Of course.

And even then though, you want as many of them as possible. You still want a lot of stocks. You want a lot of stocks. So – Okay. Now what did you want to say about what the article missed? Like what's the – I just did.

What? That even if you screen some stocks out – No, I'm saying it doesn't talk about that at all. It just basically implies that the reason why you should actually doesn't talk about indexing. Really. It really says that if you hold just say your 10 best ideas, that's probably not enough. Like 10 great stocks won't be enough.

Probably not. Now imagine one of them gets acquired. Another one gets taken private. Then you have to hunt the next two down or else you have eight stocks. How active do you want to be on revisiting this portfolio every year? So I mean, I guess it's probably true that the best money managers have concentrated portfolios, but that's like survivorship bias because all of the ones that don't. Well, let me ask you this question then, gun to your head. I tell you, you have to have a concentrated portfolio. However, I give you the choice. You can have the whole thing be concentrated or you can have half

concentrated positions you really like and then the other half just on the index alongside of it. You would obviously do the second option. What? You could do half S&P, half your biggest favorite names. I don't have favorite names. But you're saying if I were to pay somebody to do that? Yeah. So I would do like 85% beta, 15% like highest conviction names. I would pay somebody for that.

All right. So like – so Apple is 6% of the S&P. The manager has extremely high conviction in Apple. Make it 10. And not Apple. I'm bearish. But I'm just saying. Yeah.

Okay. All right. Hey, let us know what you think about concentrated positions, best idea portfolios. We love your feedback. We love your subscriptions. We love your likes. And we will talk to you soon.