John Maynard Keynes proposed that investors should hold concentrated investment portfolios.
In 1938 he described the principles he believed should underpin this style of investing. These are:
- A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;
- A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake;
- A balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible, opposed risks.
The Implications Of Concentrated Portfolios
Consider the two possible extremes in building a stock portfolio:
- The most dilute portfolio possible is one that includes every stock listed on the stock market. This can be achieved by investing using index-tracking investment trusts and mutual funds. Provided their fees are low, these funds achieve returns closely matching the return of the whole market.
- The most concentrated portfolio consists of a single stock. If an investor chooses a single stock well, its return will greatly exceed that of the general market. A bad choice may result in total loss of the investor’s funds.
The smaller the portfolio, the greater the likelyhood that its return will differ significantly from the market average.
Investors who have the competence to analyse a small number of businesses in detail and the ability to identify low-priced, outstanding businesses, will be able to outperform the market dramatically . (For example, John Maynard Keynes and Warren Buffett.)
Investors who lack the skill to select suitable stocks and who build a concentrated portfolio will probably underperform the market dramatically. (For example, any number of hopeful small investors.)
- Skilled investors can maximise their long-term return through deliberate selection of stocks.
- Unskilled investors can maximise their long-term return by adopting a deliberate policy of no selection. (They should invest in the whole market via a low cost index tracking fund.)
The Balanced Portfolio
A concentrated portfolio consisting of several stocks is immune to the risk of total loss should the value of a single holding fall to zero.
Investors, however, still run the risk of large losses if each of the stocks in their portfolio behaves in the same way – if the share prices tend to rise and fall in tandem with one another and they all fall when an unexpected, harmful event happens.
Keynes said that investors should hold investments with opposed risks. A simple example of businesses with opposed risks might be a lender and a debt collection agency. Both can prosper in a booming economy. If interest rates rise strongly, the lender’s business will probably worsen but the debt collection agency’s profits could improve.
Alternatively, a stock investor could lessen his or her exposure to risk by investing in commodities or currencies. For example, an investor decides to buy shares in a car battery manufacturer. The batteries are made using lead metal.
- If lead prices stay low the battery maker will enjoy remarkably high profits.
- If lead prices rise significantly, battery-making profits will suffer badly.
If our investor buys lead – either directly in the commodity markets, or through buying shares in a lead mining company – they will lower their risk of loss, because:
- If lead prices stay low, they will benefit from an outstanding return from the battery manufacturer.
- If lead prices rise sharply, the lower return from the battery maker will be compensated for by a greater profit from the position in lead.
Gathering together attractive but uncorrelated or opposed investments in a single portfolio is the basis of hedge funds. In his development of the Chest Fund, John Maynard Keynes was responsible for creating one of the world’s earliest hedge funds.