Portfolio Construction 101

The question of how to best construct your portfolio has been long held in the world of investment management, and even long before that, as even King Solomon had wisdom to share on the subject. The objective of managing a portfolio is to earn the highest return possible, while ensuring the safety of your principle. This question has been attempted to be answered by many academics and practitioners alike, and has formed the basis of many of the world's best investors Strategies. This essay will address the differing philosophies of portfolio construction, focusing on discretionary approaches to this problem.

Modern Portfolio Theory:

According to Modern Portfolio Theory, an investor must be compensated for a higher level of risk through higher expected returns. MPT employs the core idea of diversification – that owning a portfolio of assets from different classes is less risky than holding a portfolio of similar assets. Modern portfolio theorists believe that owning uncorrelated assets removes idiosyncratic risk (the inherent risk involved in investing in a specific asset) and that systematic risk (risk that is caused by factors beyond the control of a specific company or individual), cannot be protected against. Essentially, MPT proponents believe that volatility is what measures risk in investment decisions, and they diversify in order to avoid volatility, by having ‘uncorrelated’ assets. This is a far cry from what is is promoted by value investors like Nick Sleep, Allan Mecham, Warren Buffett and many others who view the risk in any investment as being the nature of the business you are investing in and the misanalysis of its intrinsic value - these investors actually welcome volatility and see it as merely another buying opportunity - if their original thesis has not been disproven

How fortunes are made:

If you look at the Forbes list, and research how most of the billionaires on it accumulated their wealth, they generally started and exponentially grew a single business or they bought a business and grew it substantially through subsequent mergers, acquisitions and financial engineering. It is very rare to have someone who owned a diversified portfolio of investments make it to the top of the list, and even in those examples - a very small amount of their decisions resulted in their outsized returns. i.e. In his 2022 letter to shareholders, Warren Buffett wrote,

It is no wonder that Warren Buffett, as well as Investors with comparable records, keep very concentrated portfolios. It's a philosophy that despite exposing you to ‘bumpy’ returns, will, in due time give you outsized returns. It allows you to press a bet when your confidence level is extremely high, which is the difference between a great record and a good one.

Benefits of Concentration:

The benefits of concentrating your portfolio is having all your energy, intellect, conscious and unconscious processing focused on 6-8 companies/scenarios vs spreading it across 50+ or even 500 scenario’s - which is quite typical in the professional investment management business. How could you possibly know everything about each of those companies? If there is a major structural change in an industry, how can you identify it? Why would someone choose to invest with a diversified fund vs Indexing?

By having a concentrated portfolio, you are able to build enormous conviction on your investment ideas, enabling you to get a tremendous insight that most don't see (Meaning it's not priced in) and you can make a huge bet, further the likelihood of making a mistake is lower, since the standard that needs to be met to warrant inclusion in your portfolio will be so high and you have the time to really understand all of the businesses moving parts. 

Risks in Concentration: 

The main risk in having concentrated investments is that it takes a massive psychological toll on you - as you will experience a lot of volatility if you take on such a portfolio construction. When you have a drawdown, you have to constantly check and double check your thesis and be very attentive to structural changes and key drivers of your thesis, this requires creative imagination of various scenarios as well as an intense focus on the facts that made you build the thesis. 

Your goal is to buy a company below its true value, meaning you must find an insight that is not priced in to the security,  It follows that you need to be a contrarian thinker and very comfortable in the minority, you need the psychological temperament (read detachment), to be able to make decisions independent of the crowd and to not be swayed by the whims of other market participants. This requires immense discipline, and really a psychological wiring that cannot be taught. 

The evidence and insights presented in this essay underscore the compelling advantages of a concentrated portfolio over a diversified one. While Modern Portfolio Theory champions diversification as a means to mitigate risk through spreading investments across uncorrelated assets, this approach dilutes focus and insight, often at the expense of substantial returns. Legendary investors like Warren Buffett and Stanley Druckenmiller, who have consistently outperformed the market, have demonstrated that concentrated portfolios allow for a deeper understanding of fewer investments, enabling higher conviction and more significant returns

Ultimately, the essence of successful portfolio construction lies in the balance between risk and reward. While diversification offers a safety net against volatility, it often curtails the potential for extraordinary gains. Concentration, on the other hand, demands a higher threshold of confidence and diligence but promises outsized returns for those willing to embrace its challenges. True mastery in investing comes from profound understanding and the willingness to stand firm in one's convictions, even when faced with market turbulence.

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