16
Small Slam!

For most active investment managers, the benefits of portfolio diversification can have two “performance-retarding” problems. One is the danger of diluting the expertise that could be devoted to each investment and is needed to outperform the expert competition. Another is not investing enough in the very best opportunities to make a major difference. My long-term interest in fees—and how to see them accurately—are both on display in this short piece.

My father loved bridge and played often and well, usually for serious money. He was impressed one evening when his bridge partner—an acquaintance he had not played with before—opened with a preemptive bid: “Small slam in hearts!” He was astonished when his happy partner said, “It's a laydown!” Dad was astounded as his partner showed his hand: It was all hearts! Aghast, Dad asked the obvious question, “Why didn't you bid grand slam?”

He was not amused by the reply: “Because I wasn't sure how much support your hand would give me.” Dad never fully recovered.

Bridge is a more even-handed game than investing. In tournament bridge, the penalty for underbidding is as severe as the penalty for overbidding, because both are equally “not right.” Both are equally wrong. The same should be true in measuring a portfolio manager's investment performance. For a client, the “opportunity cost” of a gain not made will be just as much a loss, over the long term, as any “real” loss. Inappropriate caution should be at least as concerning in investing as in bridge.

As investment managers, wouldn't we be more successful in achieving good results for our clients if we would force ourselves to act boldly on some strong convictions? For example, why not begin by forcing ourselves to put at least 50% of the portfolio in 10 or fewer “compelling opportunity” stocks? (Note that a client with several investment managers already has lots of diversification, including diversification of information gathering and decision making. Having each individual manager “fully diversified” surely results in an excessive number of holdings in the client's combined portfolio.)

So, our first question is the pervasive “unmentionable”: To what extent are we “closet indexers”? How much do our actual portfolios truly differ from the index? An even harder question is, what fees are we charging relative to the assets composing this differentiating portfolio—or even to the incremental return earned from this differential portfolio?

The publicly available data on institutional managers' investment results are not encouraging. On average, as we are all recurringly reminded, active managers do not beat the index, so the industry's average differentiating portfolio is not beating the market. It is getting beaten. Why? One answer may be “taking too much risk.” A better answer may be “being too cautious.” The traditional answer to the inherent difficulty in investing is to diversify. I'm not so sure. Remember H.L. Mencken's admonition: “For every complicated problem, there is a simple answer. And it's wrong!”

We know investing is a complicated problem. Is diversification a too simple answer? Diversification is widely regarded as providing a defense against uncertainty. But does it? Let's take another careful look. First, a long list of holdings is no more “portfolio diversification” than a huge pile of stones is Chartres Cathedral. Both need deliberate design and skillful construction.

Second, increasing the number of holdings dilutes our knowledge, disperses our research efforts, distracts our attention, and diminishes our determination to act—when really called for decisively and with dispatch. If you work hard enough and think deeply enough to know all about a very few investments, that knowledge can, at least theoretically, enable you to make and sustain each of your major investments with confidence. The more you “diversify” by increasing the number of different investments you must understand, the more you risk increasing your not knowing as much about each of your investments as do your best competitor investors, particularly the most expert and thus the quickest to take preemptive action.

Only a surprisingly small number of well-chosen different positions are needed to provide diversification's protection against major errors of commission. Usually, this protection against disaster can be achieved with fewer than a dozen different positions. After that, increasing the number of different investments in a portfolio can increase uncertainty more rapidly than it reduces risk.

Meanwhile, investors who are preoccupied elsewhere—or whose attention is too dispersed for them to be sufficiently attentive to “first warnings”—are not ready or able to take prompt action. Disturbingly, the very portfolio diversification intended, in theory, to protect us from risk may, in practice, actually be increasing our true uncertainty. This greater uncertainty can cause investors to make errors of commission or of omission that might have been avoided if they had been able to devote enough time to each investment.

The stock market may be a continuous demonstration of “economic democracy,” but the decisions of the most successful investors are not democratic. Investing is necessarily—as are all sports, all arts, and all sciences—a meritocracy. Philip Fisher continued to champion in writings and in practice over more than half a century owning the stocks of a few truly outstanding companies and concentrating on becoming sufficiently expert in each of them to stay serenely committed for the very long term. Mies van der Rohe, understanding the distractions of too much detail, admonished his fellow architects that “less is more.”

That is why Warren Buffett, the Great American Investor, advises investors to visualize themselves as having a lifetime “decision ticket” with only 20 numbers to punch. Each time you make a decision, punch your ticket. After 20 punches, you must leave the game. You are played out. Buffett has gone so far as to declare four of Berkshire Hathaway's investments permanent: Coca-Cola, Disney, GEICO, and the Washington Post Company. Buffett's exemplary results—from a very concentrated portfolio of very long-term holdings based on very thorough homework—give an encouraging indicator of our opportunity.

As investors, we will make better decisions if we concentrate our skills and energies on making fewer and better investments, deliberately searching for the Great Decisions. When turnover is as high as it is today, we are doing so many things that we do not make enough time to think through and do the best things in a very big way. That is what makes Warren Buffett and Phil Fisher so special. Larry Tisch is no slouch either. John Neff turned in his generation's best risk-adjusted return for large mutual funds by making astute and courageous long-term portfolio strategy decisions that were concentrated on his best, most rigorously reasoned opportunities. Consider life. How many truly important decisions do we make in our own private lives?

As investors, how many of us truly understand the importance of our “slugging average” making our best investments our very biggest? Are we doing sufficient analysis to make fewer, larger, and longer-lasting investments? Are we just “playing to play,” or are we “playing to win”? The difference is decisive. Dad would want to know whether, as investors, we are seriously looking for and truly ready to bid “Grand Slam”!