“Should You Bet Big on Few Stocks..?” - Joel Greenblatt

Well, when I first started out, I was doing very concentrated portfolios, and I did that for quite a long time, several decades. We had concentrated, by concentrated I mean six to eight stocks were 80% plus of our portfolio. When you know the businesses really well, the best way to think about these are actually businesses. Warren Buffett has a, I'm gonna paraphrase here, but he said imagine that you had a business that you sold for a million dollars, and now you wanna reinvest the money intelligently in the city where you live, and let's say there's hundreds of businesses, and you analyze them, and you find six or eight that are run by good people, have good prospects, nice returns on capital, all good things and a nice future, and you did that research, and you divided that million dollars amongst those six to eight businesses in your city that you liked all those elements to. Most people would kind of call you a prudent person. You're dividing, you did your research, but when it comes to the stock market, you can get daily quotes on those businesses. Academics would tell you you're insane. You're taking way too much risk, it's volatile, and so you really have to think in those terms. I mean, read as much Buffett as you can, but bottom line is if you wanna stay unemotional, actually think what you're doing. Think of businesses, stocks, as ownership shares of businesses. It's very, very helpful. If something happens in Greece, and you own a chain store in the Midwest, okay, are you gonna sell it at half price the next day because something happens in Greece? You're probably not even gonna think about it, but in the stock market, you're gonna get a much lower quote and bad things will happen. You'll think it's relevant in some way, and no one who actually owned the business would do anything about that. So it's better to think of businesses, I mean, stocks, as ownership shares of businesses as one way to keep yourself sane. The way we have very diversified portfolios now, because when you go long, short, and put on leverage, you need diversified portfolios, and so when we used to own How Do I Stay Sane, we used to own six or eight names, and every couple years, you would wake up, Rob and I, and we'd lose 20 or 30% of our net worth in a day or two, and it would happen like clockwork all the time. That was just the way it works. When you own six or eight things, something's not going right for your business, or you were wrong on a pick, and that just has to happen. Even if you're right most of the time, you're gonna be wrong, and that's gonna happen every couple years. Most people can't handle that, but that's just part of the game. It has to happen. It's mathematically impossible almost not to happen that way that the market, or you'll just be wrong on some when you're that concentrated, and you have to sort of know what you own and be very cold and analytical, and it's helpful when you actually think, I just own a small group of businesses. Now, when we have hundreds of stocks on the long side and short hundreds of stocks, we're trying to be the insurance company. We're trying to be right on average, and when we actually have more diversity, this is a flaw in a lot of hedge funds. It turns out, rather than buy, let's say, three, 400 of the cheapest over here, we usually weight them based on how cheap they are, and short three or 400, why wouldn't we just do the top 50 or 100 and short the bottom 50 or 100? I mean, the alpha generation's pretty linear, so why wouldn't we do that? Well, number one, these stocks all the way down here, these are extremely in-favor stocks. They're quite volatile, a lot of money losers in there. Up there, these stocks are extremely out of favor, much more volatile. You have less of them, more volatile. When you go long, short, and put on leverage, I would say, and you have less stocks, getting aberrationally bad returns is another euphemism for losses. When you go long, short, and put on leverage, you could get what you didn't expect more often when you just have a few volatile names, and you could have some negative compounding. Turns out, negative compounding's bad, as you all know the math, and so when you go long, short, and have more names up here and more names here, you have less extreme names on average. You have more names, so less extreme names, less volatile. More names, less volatile. Another way of saying you get what you expect more often, that's why insurance companies don't insure five guys no matter how good their underwriting is. If someone steps off a curb and messes up your numbers, you can tell, I don't sell insurance. So when you go long, short, and put on leverage, you get what you expect more often. You spend less time negative compounding. You actually end up with higher returns. Even though the alpha generation is linear, when you go more diversified, you end up with slightly higher returns and a lot less volatility, so there's no trade-off. So that's not really the math that most investors look at. It's not what typical hedge funds look at. They're actually very under, most of them are very under-diversified. Even though this is factual, this is what happens. So these guys did beat these guys, but by adding some of these guys, you can actually make more money by keeping less volatile. And so it's one way to, so now our bad days, to be honest, in our diversified portfolios, is we underperform by 20 or 30 basis points, so that's how we stay sane. That's our bad day. As opposed to losing 20 or 30% of our net worth. So we trained ourselves over many years by being concentrated investors for so long. So it's complicated. I would say that the best idea is to think of stocks as ownership shares of businesses and really believe that. Really don't, you know, when I got on a very big investment board and my first memo I wrote with the chairman of the committee said, oh, this is a great memo, you should hand it out. And then I almost got shot. And my suggestion, and you know, I hadn't been there, I hadn't been, it was like a really big board and I hadn't been on one yet. It was about 15 years ago. And my suggestion was stop reporting your returns to everybody else so that you just do what you think is smart long-term and you don't worry about how you compare to all the other guys on the lead table of who did the best and who did the worst. So no one really liked that idea and it might not be realistic but that's the way you should think about investing.