In our previous discussion, we said that our long-term portfolio return would depend on first, the individual return of each of our investments; and second, our portfolio construction which drives the return at the portfolio level.
Today, we will talk about this second component – The overall returns at the portfolio level, which is affected by our portfolio construction.
Portfolio diversification
One common question that investors have on portfolio construction is finding out the ideal number of stocks in a portfolio.
Ask different people and you get different answers.
Overall, different studies generally find that a portfolio containing about 10 to 30 stocks (that are not strongly correlated) offer a good level of diversification, and more stocks beyond that provide diminishing returns.
Our take is that you need to find out what suits you and your temperament.
A more diversified portfolio could provide the benefits of diversification and reduce the chances of the portfolio being wiped out by a few single mistakes.
But this is only if it doesn’t result in the diversification of mind (where one is not on top of, and does not really understand the business fundamentals of, the companies owned), where the “risk [then] comes from not knowing what you’re doing,” per Warren Buffett.
A good way to think about this is, to see owning stock as similar to having children, and don’t get involved with more than you can handle.
Meanwhile, a more concentrated portfolio is likely to lead to more volatile returns, which can be difficult to stomach for some investors, so be concentrated only to the level of your “sleeping point”, where you can sleep comfortably at night.
While ensuring a good level of diversification within your portfolio is important, that topic has been widely discussed.
What we find, to be less discussed, but very interesting and important to your long term portfolio returns, is the magic of the portfolio compounding mathematics, which we will discuss now.
The magic of portfolio compounding maths
Have you ever met an investor (let’s call him Mr Busy), who is always on the go, spending lots of time finding and talking about the next great company or investment, and from time to time talks (or brags) about the success of his individual investments?
Like “I invested in Company A four months ago, and recently I sold it for a 70% gain”, or “I found this Company B two years ago and invested in it, and recently I sold it for a 100% gain and made XX dollars of profits”.
However, you have never heard him talking about his overall long term portfolio returns, which you can probably guess why.
Meanwhile, you might have met an investor (let’s call her Ms Lazy), who doesn’t talk much about her individual investments or portfolio. Probably because she does not do much at all, so there’s nothing much to talk about. But somehow, you surprisingly find out that her overall portfolio return has actually been incredible over a long period of time.
So, what’s the difference between these two investors? Is the difference between their long term portfolio results more of a result of luck, or a result of skill or temperament?
While it’s hard to get a definitive answer, and the answer is not necessarily binary (i.e. it can be a combination of the two reasons), we think that a difference in skill or temperament definitely helps.
In particular, a skill or temperament that is widely underappreciated in today’s world.
And that’s the ability to be patient and sit and do nothing (the temperament).
Coupled with an (deep) understanding and appreciation of the power of it (the skill).
In particular, the power of the portfolio compounding maths.
Let’s try to think about the performance of a portfolio of 10 companies, with equal allocation to each of them. So, a $10,000 portfolio would have $1,000 invested in each company today.
We expect that all these 10 companies will grow 15% annually in the future. However, the business world is uncertain, and it turns out later that some of these companies are actually Toyotas, and some are Ferraris, all of different qualities.
Such that they all grow at different rates, of between 3% to 27% annually, but the simple average of the different compounding rates still turns out to be 15% (i.e. the same as the original expected compounding rate for the companies), as shown in the table below.
In this case, what do you think would be the compounding rate of the overall portfolio, after a long period of time, say after 5, 10, 15 or 20 years?.
The answers are shown in the table below, in the last row indicating the “Portfolio annual compounding rate”.
So, after 5 years, the overall portfolio annual compounding rate is actually 15.9%, higher than the 15% simple average rate.
And it actually increases over time:
to 17.0% after 10 years;
to 18.0% after 15 years;
to 18.9% after 20 years;
to 19.7% after 25 years;
to 20.3% after 30 years.
How can this magic happen?
The answer lies in the exponential effect of compounding (which is hard for the human mind to fathom).
Because the impact of compounding is not linear (but exponential), the positive impact from the great compounding of the companies that grow well greatly outweighs the negative impact from the slower (or even negative) compounding of the companies that don’t grow well.
And this magic becomes more powerful, the longer the time of compounding.
The portfolio benefits of inaction
Do the results above surprise you? And have you thought about this before?
Even though you have selected companies that on average grow by 15% annually, you are actually rewarded with an overall portfolio return of more than 15%, and which just keeps growing over time!
Isn’t that amazing?
But they say there’s no free breakfast in the world… So what’s the catch?
The catch is that you need to have the temperament to sit still and do nothing!
Which is not easy, as Blaise Pascal, a French philosopher, once said, “All of men’s miseries derive from not being able to sit in a quiet room alone”.
However, those who truly understand the magic of portfolio compounding math, and intend to ride on it (freely), would benefit from it.
Just like how Albert Einstein (purportedly) said that, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.
Several “superinvestors” understand and have been practising this for long, staying inactive and relying on this portfolio compounding math to achieve tremendous portfolio returns for themselves and their investors.
Terry Smith (from Fundsmith, with a ~16% CAGR return from 2010 to 2023) asks us to do nothing, after buying good companies and not overpaying.
Nick Sleep (from Nomad Investment Partnership, with a ~21% CAGR return from 2001 to 2014), at one point said to his investors that “Our portfolio inaction continues and we are delighted to report that purchase and sale transactions have all but ground to a halt. Our expectation is that this is a considerable source of value add!”
Pulak Prasad (from Nalanda Capital, with a ~20% CAGR return from 2007 to 2022), tells us to “Avoid big risks; buy high quality at a fair price; and don’t be lazy – be very lazy”.
Summary
Remember the stories of Mr Busy and Ms Lazy?
Although Mr Busy has found (& bragged about) several good flowers, he probably has been cutting his better flowers and watering the weeds (or less-good flowers), instead of letting his best flowers grow freely. And hence his mediocre overall portfolio return.
So, do you want to be Mr Busy, or Ms Lazy? Your choice.
We at MoneyWiseSmart will happily be Ms Lazy, without any doubts.
However, one caveat is that, we can afford to have this luxury of being lazy, only if we have initially selected companies that are of really high quality, with good capital allocations and without any red flags or big risks, so that’s an important caveat.
As time is the friend of the wonderful company, the enemy of the mediocre. And we teach our subscribers what makes good companies and investments (like looking for high ROCE, good capital allocation, avoiding red flags, and managing risks well in our investments).
Comments