7
“You Call That a Position?”
“Too much of a good thing can be wonderful.”
—MAE WEST
“[Soros taught me] it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
—STANLEY DRUCKENMILLER1
“Diversification is a protection against ignorance. [It] makes very little sense for those who know what they’re doing.”
—WARREN BUFFETT2
SOON AFTER HE TOOK OVER the Quantum Fund from Soros, Stanley Druckenmiller shorted the dollar against the German mark. The trade was showing a profit when Soros asked him, “How big a position do you have?”
“One billion dollars,” Druckenmiller answered.
“You call that a position?” Soros said, a question that has become a part of Wall Street folklore.3
Soros prompted him to double his position.
“Soros has taught me,” noted Druckenmiller, “that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.”4
“You can’t own enough” isn’t something you’ll hear from your Wall Street investment advisor. He’s more likely to follow the conventional wisdom, which states:
1. your money should be divided among stocks, bonds, and cash; and
2. your stock portfolio should have a broad range of stocks, preferably diversified among a variety of industries and even different countries.
Yet the exact opposite of diversification—concentration in a small number of investments—is central to both Buffett’s and Soros’s success.
As Fortune once put it: “One of the fictions of investing is that diversification is a key to attaining great wealth. Not true. Diversification can prevent you from losing money, but no one ever joined the billionaire’s club through a great diversification strategy.”5 To understand why, let’s translate the conventional wisdom into another arena entirely.
The Investment Advisor and Bill Gates
Imagine that this same advice were to be given to businessmen instead of investors. Businessmen like Bill Gates.
The investment advisor turned business consultant would tell the young Gates something along the following lines:
Mr. Gates, you’re making a fundamental mistake focusing all your energies on the software business. Diversify, diversify, diversify … that’s the secret of success.
Right now, as you’re starting your business, it’s the time to set a sound course that will ensure your ultimate success and prosperity.
With DOS, you’re a single-product company. All your eggs are in one basket. Very dangerous.
Instead of just making software, why not make computers as well? But give serious consideration to balancing the high-risk business you’re in with some other business ventures that will be more stable and countercyclical. Utilities, for example, are very stable businesses.
And what if the same advisor were asked to make career recommendations to the young Pavarotti?
Opera singing is all very well, but after all the returns to be had aren’t all that great.
Sure, I know you really love opera. And I’m certainly not going to advise you to give it up. Far from it.
But I urge you to consider the virtues of diversifying your repertoire into rock and other more popular types of music. After all, you’ve got to think about paying the rent.
In any event, the career you’ve chosen is exceedingly risky. So few people achieve fame and fortune as opera singers—or rock singers, for that matter.
Do you have any other, nonmusical interests?
Good. Cooking is much safer, sounder field. Why not get some training in that part-time so you’ll always have something to fall back on?
When put like this, it sounds ridiculous doesn’t it? You immediately grasp that this is foolish advice to give to a Gates or a Pavarotti—or anyone else, genius or not.
Yet that’s exactly what most investment advisors counsel.
Every successful person, regardless of the field, is single-minded in the pursuit of his goal. They do NOT diversify their energies into a variety of fields.
The result of such single-minded devotion to the achievement of one goal is Mastery.
Like the diversified investor, the jack-of-all-trades is master of none; so he is rarely as successful as the person who devotes his entire energy to the single-minded pursuit of a single goal.
The reason is simple—and obvious in any field except investing:
• Your time and energy are limited. The more widely you spread your energies, the less you can spend on any one activity.
To quote from the legendary investor Bernard Baruch (who sold all his stocks before the crash of 1929):
“It is unwise to spread one’s funds over too many different securities. Time and energy are required to keep abreast of the forces that may change the value of a security. While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues.”6 [Emphasis added.]
Diversification—or concentration—of an investment portfolio directly correlates with the amount of time and energy put into making the selections. The more diversification, the less time for each decision.
Diversification and Fear of Risk
The conventional wisdom is like an empty litany that has been repeated so often everyone assumes it to be true. You’ll hear it from just about every stockbroker or investment analyst. But ask him to justify diversification, and what you’ll find at the bottom of this school of money management is the fear of risk.
Fear of risk is a legitimate fear—it’s the fear of losing money (and so breaking the First Rule of Investing).
But Master Investors don’t fear risk, because they passionately and actively avoid it. Fear results from uncertainty about the outcome, and the Master Investor only makes an investment when he has strong reasons to believe he’ll achieve the result he wants.
Unlike the Master Investor, those who follow the conventional advice to diversify simply don’t understand the nature of risk, and they don’t believe it is possible to avoid risk and make money at the same time.
Worse, while diversification is certainly a method for minimizing risk, it has one unfortunate side effect: It also minimizes profit!
How Diversification Suffocates Your Profits
Compare two portfolios. The first is diversified among one hundred different stocks; the second is concentrated, with just five.
If one of the stocks in the diversified portfolio doubles in price, the value of the entire portfolio rises just 1 percent. The same stock in the concentrated portfolio pushes the investor’s net worth up 20 percent.
For the diversified investor to achieve the same result, twenty of the stocks in his portfolio must double—or one of them has to go up 2,000%. Now, what do you think is easier to do:
• identify one stock that’s likely to double in price; or
• identify twenty stocks that are likely to double?
No contest, right?
Of course, on the other side of the coin, if one of the diversified investor’s stocks drops in half, his net worth only declines 0.5 percent. If the same thing happens in the second portfolio, the concentrated investor sees his wealth drop 10 percent.
But let me ask you the same question again … which is easier to do:
• identify 100 stocks that are unlikely to fall in price; or
• identify five stocks that are unlikely to fall in price?
Same answer: no contest.
And here we have the key to one difference between the average investor and the Master Investor: Because the Master Investor’s portfolio is concentrated, he focuses his energies far more intensely—and far more effectively—on identifying the right investments.
However, concentration is the effect, not the cause. The Master Investor doesn’t set out deliberately to hold only a few investments. Concentration stems from the way the Master Investor selects his investments.
He spends his time and energy searching for high probability events that meet his criteria. When he finds one, he knows the risk of losing money is low. There’s no fear of risk to hold him back.
Second, high probability events are hard to discover. Who knows when he’ll find the next one? What’s the point in sitting on a pile of cash waiting for an opportunity that may be a long time coming when, right now, he can see piles of money sitting on the table, begging to be scooped up?
When Buffett and Soros buy, they buy big.
There’s a Wall Street saying: “Bears make money, bulls make money, but pigs get slaughtered.” It should be amended to read “pigs who don’t know what they’re doing get slaughtered.”
“Go for the Jugular”
Buffett’s and Soros’s portfolios clearly don’t follow any simple rule of position sizing, such as an equal percentage in each investment.
Neither’s portfolio gives any clue as to how it was assembled.
That’s because they buy good investments as they discover them. Whatever opportunities they saw, they took—and that’s why their portfolios look the way they do today.
The only rule they follow is one you’ll never learn from your stockbroker: expectancy of gain. The higher their expectancy of profit, the greater the percentage of their portfolio they’ll devote to that investment.
Expectancy of gain is something that can and should be measured or estimated. For example: Buffett is looking at two companies. One is returning 15 percent on capital and the other 25 percent on capital. The shares of both are available at prices he’s willing to pay. He would clearly prefer to put more money into the second company.
With the river of cash that Berkshire Hathaway’s investments and insurance operations are throwing off every year, Buffett’s main problem now is finding enough high probability events to invest in. So he would probably buy both.
But if you or I, with our somewhat more limited resources, were following Buffett’s approach, we’d buy stock only in the second company. We’d ignore the first one completely. And if we already owned it, we’d probably sell it to put more into the stock that has the far higher expectancy of gain.
So the Master Investor doesn’t set out with the aim of devising a concentrated portfolio.
Rather, concentration results from the way he approaches investing. When Buffett and Soros are certain they’re going to make money, their only limit is how much they can buy.
They don’t give damn how their portfolio “looks.” They just want to make money.
The Investment That Makes a Difference
Over lunch one afternoon my companions—mostly Asian stockbrokers—began reminiscing about the killings they’d made when the Asian markets crashed in 1997. They talked about the blue chip stocks they’d bought at a quarter or a tenth of their current prices.
Whenever investors get together, reminiscing about past successes like this is the kind of talk you’ll expect to hear.
But what percentage of their assets had they put into these bargain-basement blue chips in 1997? Since, by and large, they’d focused on the prices they’d paid, not the profits they’d made, I just didn’t have the heart to ask. I’m sure their answers would have turned an enjoyable lunch into a wake for all the profits they’d missed.
At such times Buffett, by comparison, loads up to the gills with bargains. He says he feels like an oversexed guy in a whorehouse, and his main complaint is that he doesn’t have enough money to buy all the bargains he can see.
At other times, when he sees a stock he really likes (like Coke), he’ll simply buy as much as he can.
Soros has a similar attitude. In 1985, convinced that Jaguar was turning around and the car would become a hot seller in the United States, the Quantum Fund had put $20 million, nearly 5% of its assets, in the stock—a huge position for most funds.
Allan Raphael, who’d initiated the investment, told Soros that it was panning out just as he’d thought and that he was happy with the position. So he was stunned when Soros’s reaction was to immediately tell his traders: “Buy another quarter of a million shares of Jaguar.…
“If the stock goes up, you buy more. You don’t care how big the position gets as part of your portfolio. If you get it right, then build.”7
To Soros, investment success comes from “preservation of capital and home runs.”8
Likewise, Buffett wants investments that are “large enough to have a worthwhile impact on Berkshire’s”9 net worth.
Neither of them buys piddling amounts. When the opportunity presents itself, they buy enough to make a real difference to their wealth.
“[The trustees] wanted me to diversify. Bugger that.”
—Jim Millner10