Links

"Success in gambling doesn’t go to those who pick winners, but to those with the ability to identify superior propositions.  The goal is to find situations where the odds are generous to one side or the other, whether favorite or underdog.  In other words, a mispricing. It’s exactly the same in investing.  People often say to me, 'XYZ is a great company with a bright future, so I bought the stock.'  They’re picking a favorite but ignoring the proposition.  The former alone isn’t enough; they should consider the latter as well.... While in investing we generally aren’t offered explicit odds, the attractiveness of the proposition is established by the price of the asset, the ratio of the potential payoff to the amount risked, and what we perceive to be the chance of winning versus losing." --Howard Marks‬ ("You Bet!")

Howard Marks on Bloomberg TV (video) (LINK)

Risk Is What You Don’t See - by Morgan Housel (LINK)

Visa, Plaid, Networks, and Jobs - by Ben Thompson (LINK)

Masters in Business Podcast: Matthew Benkendorf on Managing Equities (LINK)

Invest Like the Best Podcast: Matt Clifford – Investing Pre-Company (LINK)

Matt Ridley: Get Brexit Done (LINK)

The Bleak Future of Australian Wildlife - by Ed Yong (LINK)

Links

"It’s better to pay attention to something that is being scorned than something that’s being championed." --Warren Buffett (2005) 

What Warren Buffett's Teacher Would Make of Today's Market - by Jason Zweig ($) (LINK)

A Thread on Diversification - by Sanjay Bakshi (LINK)

Amazon's Size Is Becoming a Problem---for Amazon ($) (LINK)

Degrees of Confidence - by Morgan Housel (LINK)

Think Again – a Big Think Podcast: Jared Diamond (LINK)

Related book: Upheaval: Turning Points for Nations in Crisis

Capital Allocators Podcast: Michael Mauboussin – Who’s on the Other Side (LINK)

Related paper: Who Is On the Other Side?

Exponent Podcast: A Perfect Meal (LINK)

Aswath Damodaran chats with Meb Faber (podcast) (LINK)

Acquired Podcast: The Uber IPO (LINK)

Mark Zuckerberg & Yuval Noah Harari in Conversation (video) (LINK)

When the first stars in the Universe exploded, they really exploded - by Phil Plait (LINK)

TED Talk: Sleep is your superpower | Matt Walker (LINK)

[I'm a bit late to these, but...] The Bruce Lee Library episodes of the Bruce Lee Podcast look especially worth checking out.... Such as the episode on the Tao Te Ching and the episode on Krishnamurti's Commentaries on Living.

"Absorb what is useful, reject what is useless, add what is essentially your own." --Bruce Lee

Links

"There is less risk in owning three easy-to-identify, wonderful businesses than there is in owning 50 well-known, big businesses.... If you find three wonderful businesses in your life, you’ll get very rich." --Warren Buffett (1996)

"If you’re right about the companies, you can hold them at pretty high values." --Charlie Munger (1996)

"We really have a great reluctance to sell businesses where we like both the business and the people. So I don’t think I’d count on seeing many sales. But if you ever attend a meeting here, and there are [holdings at] 60 or 70 times earnings, keep an eye on me.... You can really hold them at extraordinary levels if you’ve got [wonderful businesses]." --Warren Buffett (1996)

"Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10 percent too high or 5 percent too high or something of the sort." --Warren Buffett (1997)

"All intelligent investing is value investing. You have to acquire more than you really pay for, and that’s a value judgment. But you can look for more than you’re paying for in a lot of different ways. You can use filters to sift the investment universe. And if you stick with stocks that can’t possibly be wonderful to just put away in your safe deposit box for 40 years, but are underpriced, then you have to keep moving around all the time. As they get closer to what you think the real value is, you have to sell them, and then find others. And so, it’s an active kind of investing. The investing where you find a few great companies and just sit on your ass because you’ve correctly predicted the future, that is what it’s very nice to be good at." --Charlie Munger (2000)

Warren Buffett and Charlie Munger on diversification (video excerpt from the 1996 Berkshire Hathaway Annual Meeting) (LINK)

Related previous post: Charlie Munger on diversification

***

The BuzzFeed Lesson - by Ben Thompson (LINK)

Greenhaven Road Capital's Q4 Letter (LINK)

Horizon Kinetics Q4 Commentary [H/T @chriswmayer] (LINK) [There are also a bunch more Q4 investor letters posted HERE.]

For Bill Simmons’s The Ringer, Podcasting Is the Main Event ($) (LINK)

Patrick Collison, co-founder and CEO of Stripe, on EconTalk (podcast) (LINK)

Opportunity costs just went up - by Seth Godin (LINK)

Getting Ahead By Being Inefficient (LINK)

Charlie Munger on diversification

From the 2008 Berkshire Hathaway Annual Meeting:

Students of America go to these elite business schools and law schools and they learn corporate finance the way it’s now taught and investment management the way it’s now taught.

And some of these people write articles in the newspaper and other places and they say, “Well, the whole secret of investment is diversification.” That’s the mantra. 

They’ve got it exactly back-ass-ward. The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. 

Diversification is for the know-nothing investor; it’s not for the professional. 

....................

Related previous posts:

Warren Buffett on Diversification - 1966

Warren Buffett on Diversification (1998)

Phil Fisher on diversification

More from Phil Fisher on diversification

Warren Buffett and Charlie Munger on portfolio concentration, and having the right temperament for it

Seth Klarman on position sizing (bottom paragraph)

Mohnish Pabrai on position sizing

Generalizing the Kelly Criterion

A quick diversification thought...

A few comments on the Berkshire Hathaway letter to shareholders

Inevitables vs. Highly Probables

From Warren Buffett's 1996 Letter to Shareholders:

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables."  Forecasters may differ a bit in their predictions of  exactly how much soft drink or shaving-equipment business these companies  will be doing in ten or twenty years.  Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation.  In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly -questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen.  Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade. 

Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables.  But I would rather be certain of a good result than hopeful of a great one. 

Of course, Charlie and I can identify only a few Inevitables, even after a lifetime of looking for them.  Leadership alone provides no certainties:  Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility.  Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish Survival of the Fattest as almost a natural law, most do not.  Thus, for every Inevitable, there are dozens of Impostors, companies now riding high but vulnerable to competitive attacks.  Considering what it takes to be an Inevitable, Charlie and I recognize that we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty.  To the Inevitables in our portfolio, therefore, we add a few "Highly Probables." 

You can, of course, pay too much for even the best of businesses.  The overpayment risk surfaces periodically and, in our opinion, may now be quite high for the purchasers of virtually all stocks, The Inevitables included.  Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid. 

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse.  When that happens, the suffering of investors is often prolonged.  Unfortunately, that is precisely what transpired years ago at both Coke and Gillette.  (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?)  Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.  All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.  

Mr. Buffett also added a little more in response to a question at the 1997 annual meeting about whether or not McDonald's fit in the same category as Coca-Cola and Gillette:

In the annual report, we talked about Coca-Cola and Gillette in terms of their base business being what I call “The Inevitables.” But that related, obviously, to the soft drink business in the case of Coca-Cola and the shaving products with Gillette. It doesn’t extend to necessarily everything they do. But fortunately in both those companies those are very important products.  

I would say that in the food business, you would never get the total certainty of dominance that you would get in products like Coca-Cola and Gillette. People move around in the food business, from where they eat, from — they may favor McDonald’s but they will go to different places at different times. And somebody starts shaving with a Gillette Sensor Plus is very unlikely to go elsewhere, in my view.  

So they do not — you just — you never would get in the food business, in my judgment, quite the inevitability that you would get in the soft drink business with a Coca-Cola.  

You’ll never get it again in the soft drink business. I mean, it took a hundred — I guess it’d be 1886, so it’d be about 111 years to get to the point where they are. And the infrastructure’s incredible, and — so I wouldn’t put it quite in the same class, in terms of inevitability. 

And then he added more color in his answer to the next question at that meeting:

But I should — I’m glad you brought up the subject of the annual report. Because what I was doing in the annual report is I had talked about Coke and Gillette as being “The Inevitables,” and what wonderful businesses they were.  

And I thought it appropriate, particularly — the report goes to a lot of people — that they would not take that as an unqualified buy recommendation about the companies, because they’re absolutely wonderful companies run by outstanding managers.  

But you can pay too much, at least in the short run, for businesses like that. So I thought it was only appropriate to point out that no matter how wonderful a business it is, that there always is a risk that you will pay a price where it will take a few years for the business to catch up with the stock. That the stock can get ahead of the business.  

And I don’t know where that point is with those companies or any other companies, but I did say that I thought that the risks were fairly high that that situation existed with most securities in the market, including companies such as “The Inevitables.”  

But it was designed to be sure that people did not take the remarks that I made about those companies, and just take that as an unqualified buy recommendation regardless of price.  

We have no intention of selling those two stocks. We wouldn’t sell them if they were selling at prices considerably higher than they are now.  

But I didn’t want — particularly — relatively unsophisticated people to see those names there and then think, “This guy is touting these as a wonderful buy.” Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10 percent too high or 5 percent too high or something of the sort.  

And that’s a philosophy that I came slowly to. I originally was incredibly price conscious. We used to have prayer meetings before we would raise our bid an eighth, you know, around the office. (Laughter)  

But that was a mistake. And in some cases, a huge mistake. I mean, we’ve missed things because of that.  

And so what I said in the report was not a market prediction in any sense. We never try to predict the stock market.  

We do try to price securities. We try to price businesses, is what we try to do. And we find it hard to find wonderful, good, average, substandard businesses that look to us like they’re cheap now. But, you know, you don’t always get a chance to buy things cheap. 

More on the Kelly Formula...

From The Warren Buffett Portfolio:

Because the risk of overbetting far outweighs the penalties of underbetting, investors particularly those who are just beginning to use a focus investment strategy—should use fractional Kelly bets. Unfortunately, minimizing your bets also minimizes your potential gain. However, because the relationship in the Kelly model is parabolic, the penalty for underbetting is not severe. A half-Kelly, which reduces the amount of the bet by 50 percent, reduces the potential growth rate by only 25 percent. 

This seems a good place to summarize: 

1. To receive the benefit of the Kelly model, you must first be willing to think about buying stocks in terms of probabilities. 

2. You must be willing to play the game long enough to achieve its rewards. 

3. You must avoid using leverage, with its unfortunate consequence. 

4. You should demand a margin of safety with each bet you make. 

"The Kelly system is for people who simply want to compound their capital and see it grow to very large numbers over time," says Ed Thorp. "If you have a lot of time and a lot of patience, then it's the right function for you."

....................

Related previous posts:

Generalizing the Kelly Criterion

A quick diversification thought...

A few comments on the Berkshire Hathaway letter to shareholders

Warren Buffett and Charlie Munger on portfolio concentration, and having the right temperament for it

Warren Buffett and Charlie Munger on portfolio concentration, and having the right temperament for it

More from the excellent book Concentrated Investing: Strategies of the World's Greatest Concentrated Value Investors...

A short quote from Warren Buffett in 2008 (similar to his 1998 comments):

If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice. . . . [Berkshire vice-chairman] Charlie [Munger] and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.

And then a longer excerpt from the book about Charlie Munger's style:

In the book Damn Right!, Buffett told Munger’s biographer Janet Lowe that Munger initially followed the fundamentals of value investment established by Graham, but was always far more concentrated than other traditional value investors like Walter Schloss: 

Charlie’s portfolio was concentrated in very few securities and therefore his record was much more volatile but it was based on the same discount-from-value approach. He was willing to accept greater peaks and valleys of performance, and he happens to be a fellow whose whole psyche goes toward concentration, with results shown.  

Munger defines “very few securities” as “no more than three:”  

My own inquiries on that subject were just to assume that I could find a few things, say three, each which had a substantial statistical expectancy of outperforming averages without creating catastrophe. If I could find three of those, what were the chances my pending record wouldn’t be pretty damn good. I just sort of worked that out by iteration. That was my academic study—high school algebra and common sense. 

Munger’s rationale for holding so few stocks was based on practical considerations—“How could one man know enough [to] own a flowing portfolio of 150 securities and always outperform the averages? That would be a considerable stump.” He believes that securities are mostly appropriately valued: 

[T]he people that came up with the efficient market theory weren’t totally crazy, but they pushed their idea too far. The idea is roughly right with exceptions. 

That observation, and his own research, pressed him to seek only the handful of situations where he might have an edge: 

It would not be too much to say it was obvious to me that I could not have a big edge over everybody else and all securities. In other words, it was also obvious to me that if I worked at it, I would find a few things in which I had an unusual degree of competence. It was natural for me to think in terms of opportunity costs. So once I owned three securities—A, B, and C—I wasn’t going to buy any other security. I had actually studied them. I don’t know how much diversification would be necessary over a long period of time. I worked it out with pencil and paper as a matter of probabilities. If you are going to operate for 30 years and only own 3 securities but you had an expectancy of outperforming averages of say 4 points a year or something like that on each of those 3 securities, how much of a chance are you taking when you get a wildly worse result on the average. I’d work that out mathematically and assuming you’d stay for 30 years you’d have a more volatile record but the long-term expectancy was—in terms of disaster prevention—plenty good enough for 3 securities. I had worked that out in my own head using just high school algebra. 

In seeking his edge, Munger pursued small, unknown stocks that wouldn’t be of interest to the bigger investors: 

I tended to operate, as so many successful value investors do, not looking at Exxon and Royal Dutch and Procter & Gamble and Coca-Cola. Most of the value investors, if you analyze who’ve been successful over a long time, have operated in less followed stocks. 

Like Simpson, Munger likes “financial cannibals,” companies that buy back a lot of stock: 

[W]hat those [successful] companies had in common was they bought huge amounts of their own stock and that contributed enormously to the ending record. Lou, Warren, and I would always think the average manager diversifying his company with surplus cash that’s been earned more than half the time they’ll screw it up. They’ll pay too high a price and so on. In many cases they’ll buy things where an idiot could see they would have been better to buy their own stock than buy this diversifying investment. And so somebody with that mind-set would be naturally drawn to what Jim Gibson used to call “financial cannibals,” people that were eating themselves. 

Munger often refers to the value “mind-set.” He considers temperament a crucial element to holding a concentrated portfolio. When Buffett installed Lou Simpson as GEICO’s chief investment officer, Munger recognized in him the right temperament, and a kindred spirit: 

Warren has this theory that if you’ve got a lot of extra IQ points in managing money you can throw them away. He’s being extreme of course; the IQ points are helpful. He’s right in the sense that you can’t [teach] temperament. Conscientious employment, and a very good mind will outperform a brilliant mind that doesn’t know its own limits and so on and so on. Now Lou happens to be very smart but I would say his basic temperament was a big factor. He has the temperament of the kind of investor we like and we are.

...................

For those curious about what kind of upside vs. downside one would need to justify Munger's 3-stock portfolio according to the Kelly Formula, I touched on this in a post last year: 

If you're assuming 50/50 odds of being right (which is hopefully conservative), then you'd need a 3x upside vs. downside ratio over your investing timeframe before investing. 

As an example, if you are following Kelly and assuming 50/50 odds of being right, you'd need a 150% (2.5x) expected return if your worst-case downside is a 50% loss. And to repeat some of my thoughts on Kelly, I don't think one should try and use it precisely because you can't know the exact odds or payoffs when making an investment. But I think it's a useful tool to use when thinking about position sizing and the attractiveness of a given investment. And its usefulness reminds me of one of my favorite quotes from Munger:

"I could see that I was not going to cope as well as I wished with life unless I could acquire a better theory-structure on which to hang my observations and experiences. By then, my craving for more theory had a long history. Partly, I had always loved theory as an aid in puzzle solving and as a means of satisfying my monkey-like-curiosity. And, partly, I had found that theory-structure was a superpower in helping one get what one wanted. As I had early discovered in school wherein I had excelled without labor, guided by theory, while many others, without mastery of theory failed despite monstrous effort. Better theory I thought had always worked for me and, if now available could make me acquire capital and independence faster and better assist everything I loved."

As I wrote previously, a high level of concentration is only good "if you are willing to put in the significant effort required to deeply understand each investment." There is a big difference in the amount of work necessary to run a 5-10 stock portfolio (or less in Munger's case), and the amount of work needed to run a 20-30 stock portfolio. And as Buffett recommends, if you aren't willing to put in the work necessary in either of those cases or don't have the skill to find capable managers that do, then indexing is probably the way to go.

Warren Buffett on Diversification (1998)

This was from his 1998 lecture at the University of Florida, and was brought back to my attention through Jeremy Miller's excellent new book, Warren Buffett's Ground Rules: Words of Wisdom from the Partnership Letters of the World's Greatest Investor:

"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is [going to] be a terrible mistake. Very few people have gotten rich on their seventh best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I [would] probably have half of [it in] what I like best."

....................

Related previous post: A quick diversification thought...

More from Phil Fisher on diversification

From Common Stocks and Uncommon Profits and Other Writings:

Usually a very long list of securities is not a sign of the brilliant investor, but of one who is unsure of himself. If the investor owns stock in so many companies that he cannot keep in touch with their managements directly or indirectly, he is rather sure to end up in worse shape than if he had owned stock in too few companies. An investor should always realize that some mistakes are going to be made and that he should have sufficient diversification so that an occasional mistake will not prove crippling. However, beyond this point he should take extreme care to own not the most, but the best. In the field of common stocks, a little bit of a great many can never be more than a poor substitute for a few of the outstanding.

Phil Fisher on diversification

From Common Stocks and Uncommon Profits and Other Writings:

No investment principle is more widely acclaimed than diversification. (Some cynics have hinted that this is because the concept is so simple that even stock brokers can understand it!) Be that as it may, there is very little chance of the average investor being influenced to practice insufficient diversification. The horrors of what can happen to those who “put all their eggs in one basket” are too constantly being expounded.  

Too few people, however, give sufficient thought to the evils of the other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them. For example, among investors with common stock holdings having a market value of a quarter to a half million dollars, the percentage who own twenty-five or more different stocks is appalling. It is not this number of twenty-five or more which itself is appalling. Rather it is that in the great majority of instances only a small percentage of such holdings is in attractive stocks about which the investor or his advisor has a high degree of knowledge. Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.  

How much diversification is really necessary and how much is dangerous? It is somewhat like infantrymen stacking rifles. A rifleman cannot get as firm a stack by balancing two rifles as he can by using five or six properly placed. However, he can get just as secure a stack with five as he could with fifty. In this matter of diversification, however, there is one big difference between stacking rifles and common stocks. With rifles, the number needed for a firm stack does not usually depend on the kind of rifle used. With stocks, the nature of the stock itself has a tremendous amount to do with the amount of diversification actually needed. 

Some companies, such as most of the major chemical manufacturers, have a considerable degree of diversification within the company itself. While all of their products may be classified as chemicals, many of these chemicals may have most of the attributes found in products from completely different industries. Some may have completely different manufacturing problems. They may be sold against different competition to different types of customers. Furthermore at times when only one type of chemical is involved, the customer group may be such a broad section of industry that a considerable element of internal diversification may still be present.  

The breadth and depth of a company's management personnel—that is, how far a company has progressed away from one-man management—are also important factors in deciding how much diversification protection is intrinsically needed. Finally, holdings in highly cyclical industries—that is, those that fluctuate sharply with changes in the state of the business cycle—also inherently require being balanced by somewhat greater diversification than do shares in lines less subject to this type of intermittent fluctuation.  

This difference between the amount of internal diversification found in stocks makes it impossible to set down hard and fast rules as to the minimum amount of diversification the average investor requires for optimum results. The relationship between the industries involved will also be a factor. For example, an investor with ten stocks in equal amounts, but eight of them bank stocks, may have completely inadequate diversification. In contrast, the same investor with each of his ten stocks in a completely different industry may have far more diversification than he really needs.

Links

I will be mostly without internet for the next couple of weeks. I have a few quotes and book excerpts scheduled, but this may be the last compilation of links during that time.

AMA on Charlie Munger: What did Charlie Munger Learn from Phil Fisher? (LINK)

Farnam Street: Lifelong Learning (LINK)

The Root of Wisdom: Why Old People Learn Better (LINK)

Track and Measure (LINK)

If you listed the habits of successful people, tracking and measuring would be near the top of that list. I see it with people, companies, and teams that I work with. I see it in my own behavior.

Ron Baron interviews Elon Musk at the Baron Investment Conference (video) [H/T ValueWalk] (LINK)

Related book: Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future

Richard Duncan: Yuan Devaluation Likely (LINK)

Hussman Weekly Market Comment: Psychological Whiplash (LINK)

On a 10-12 year horizon, we expect the total return of the S&P 500 to fall short of 1% annually, and given that more than that amount is likely to represent dividends, it follows that we expect the level of the S&P 500 Index to be lower 10-12 years from now than it is today (recall a similar outcome after the 2000 peak). On a shorter horizon, market action remains unfavorable as well, which leaves prospective outcomes skewed to the downside, but we don’t need to take a particularly strong near-term view. Stocks appear to be in an extended top formation much like 2000 and 2007, so our inclination is more toward patient discipline than aggressive expectations of imminent market losses.

Ray Dalio Talks Meditating With Martin Scorsese (video) (LINK)

Stoic movie review: The Martian [H/T @TimHarford] (LINK)

In 5 Minutes, He Lets the Blind See (article and video) (LINK)

When the Sun Went Medieval on Our Planet (LINK)

Here's a link to a post from earlier this year that I've been discussing among friends, related to position-sizing: A quick diversification thought...

Which also reminded me of this quote from Warren Buffett that I posted around the same time:

"If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification... If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice... Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up."

On Twitter, Ian Cassel also posted a great quote from Charlie Munger:

"Students learn corporate finance at business schools. They are taught that the whole secret is diversification. But the exact rule is the opposite. The ‘know-nothing’ investor should practice diversification, but it is crazy if you are an expert. The goal of investment is to find situations where it is safe not to diversify. If you only put 20% into the opportunity of a life-time, you are not being rational. Very seldom do we get to buy as much of any good idea as we would like to."

Related book to the above (Kelly formula): Fortune's Formula

Book of the day: Merchants of Doubt: How a Handful of Scientists Obscured the Truth on Issues from Tobacco Smoke to Global Warming

Links

Value Investing Community Loses a Legend: Irving Kahn (1905 – 2015) (LINK)

Webinar: Portfolio Construction, Concentration and Diversification for Value Investors - By Tobias Carlisle (LINK) ["If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification... If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice... Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up." -Warren Buffett]

Related recent post: A quick diversification thought...

Baupost Details Risk Management, Hedging In Q4 Letter (LINK)

Money creation in the modern economy (LINK)

This article explains how the majority of money in the modern economy is created by commercial banks making loans. Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

The Brooklyn Investor: PM Investor Day 2015 (LINK)

Paul Graham: What Microsoft Is this the Altair Basic of? (LINK)

One of the most valuable exercises you can try if you want to understand startups is to look at the most successful companies and explain why they were not as lame as they seemed when they first launched. Because they practically all seemed lame at first. Not just small, lame. Not just the first step up a big mountain. More like the first step into a swamp.

A Basic interpreter for the Altair? How could that ever grow into a giant company? People sleeping on airbeds in strangers' apartments? A web site for college students to stalk one another? A wimpy little single-board computer for hobbyists that used a TV as a monitor? A new search engine, when there were already about 10, and they were all trying to de-emphasize search? These ideas didn't just seem small. They seemed wrong. They were the kind of ideas you could not merely ignore, but ridicule.

Often the founders themselves didn't know why their ideas were promising. They were attracted to these ideas by instinct, because they were living in the future and they sensed that something was missing. But they could not have put into words exactly how their ugly ducklings were going to grow into big, beautiful swans.

Book of the day (H/T Graham & Doddsville): Storage and Stability

A quick diversification thought...

An old post worth reviewing: Warren Buffett on Diversification - 1966 

I was reminded of Buffett's thoughts as I was once again thinking about optimal portfolio size for the "know something" investor. If you can consistently find ideas where you make 50% more when you are right than you lose when you are wrong, then even if you are right only 50% of the time, the Kelly Formula would say that you should be making 16.67% position sizes, or a total portfolio of 6 positions. 

While I think those odds and payouts are pretty conservative for the investor that really puts in the work and has a developed a good process, even being more conservative and betting 1/2 Kelly would yield an optimal portfolio of just 12 positions. Considering most of us are looking for traits that give us better than 50/50 odds of being right, and potential upside vs. downside ratios much higher than the above example, I think a portfolio composed of 6-12 core positions also adds some protection for the difficulty, or impossibility, of estimating odds and precise payouts. 

Of course, the odds and payouts change as prices change, and certain things may be being bought or sold over time, which could lead to one having a few more positions. But if you are fully invested in things that meet the general purchase criteria for most value investors, and if you are willing to put in the significant effort required to deeply understand each investment, then a portfolio of 6-12 core holdings seems about right to me. 

And I think the most common danger area with having this kind of concentration--among the things that one has some control over--is being wrong about the downside risk in each investment, and so that analysis is probably especially important. As Alice Schroeder wrote about Buffett: "He will pass on huge upside opportunities if he can't get downside protection..." Or as Howard Marks often says, if you avoid the losers the winners will take care of themselves.