THE WARREN BUFFETT PORTFOLIO (1980 - PRESENT) - YouTube

Getting above average returns in the stock market is not only a function of picking the right stocks

It is also a function of structuring your portfolio in a clever manner

Warren Buffett is the greatest investor of all time,

so I think he is the best subject to study to learn about portfolio allocation. In this video

you will learn that his approach, which could be called "focus investing", differs a lot from what you might have heard before

and/or have been taught in school

This is a top 5 takeaway summary of The Warren Buffett Portfolio, written by Robert Hagstrom

And this is The Swedish Investor, bringing you the best tips and tools for reaching financial freedom through stock market investing

Takeaway number 1: Focus investing

Perhaps you noticed in the introduction

Since 1980, Warren Buffett has almost always had the top five companies of the portfolio of his company, Berkshire Hathaway,

representing more than 50% of the total

In 1990 they were almost 70% of the total, and this was at a time when the company had close to a $10 billion valuation,

or in other words, it had quite a large portfolio

This approach could be called focus investing. The essence of it is this:

Bet big on a few stocks that are likely to produce above average returns over the long run

and stick with these stocks through short-term fluctuations

There are many advantages to this approach

compared to the ultra diversified portfolios that many of the money managers on Wall Street run these days

Firstly, it reduces costs

There are many things that are quite unpredictable in the stock market, but costs is not one of them

A focus portfolio reduces the costs of investing both in terms of transaction fees and in terms of taxes

The difference between running a high-cost portfolio and a low-cost one is

quite astonishing and you can learn more about this in my summary of The Investment Zoo

Secondly, it increases your chances of over performance

Before writing this book, Robert Hagstrom ran a simulation, testing how

3,000 randomly generated portfolios would perform during a period of 10 years

3000 portfolios with 250 stocks in each

3000 with 100, 3000 with 50, and 3,000 with 15 stocks in each

This study shows some interesting results

Among the portfolios with

250 stocks in each, the maximum returns of any portfolio during the period was 16% annually

Even this best of performing portfolios didn't over perform the general market in any significant way

Among those with 100 stocks the best one had 18.3% yearly returns

50 stocks, 19.2%

And finally, among the portfolios consisting of 15 stocks, 26.6%

So ...

Focus portfolios beat the market by significant margins much more often than diversified ones

Coincidentally, they also underperform the market to a significant degree more often when you look at it from a theoretical standpoint,

but I'll explain why this isn't necessarily the case in practice in the next takeaway

Thirdly, it reduces risk

Yes - reduces

When risk is defined in the only manner that risk can intelligently be defined in,

it lowers the risk of your portfolio to use focus investing. You learn why in takeaway number 3

Takeaway number 2: The higher the probabilities the bigger the bets

According to Warren Buffett:

"Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain."

"That is what we're trying to do. It's imperfect but that's what it's all about"

Inevitably, some stocks will have higher probabilities for above average returns than others. As a focus investor,

you should tweak your portfolio accordingly

Let's get back to the animations from the intro of the video again

The outstanding returns of Warren Buffett's Berkshire Hathaway can, to a large extent,

be attributed to the fact that he was willing to bet big when the odds were

overwhelmingly in his favor

Berkshire wouldn't have been Berkshire without large bets in companies like GEICO, American Express, Coca-cola,

Wells Fargo and BNSF Railway

An interesting corollary to the fact that you should bet bigger the higher the probabilities are,

is that you should always use your current best holding as a

benchmark for buying new ones

For example,:

If you own Apple currently and you've calculated that the company should be worth something

like two times more the current price of the stock, you shouldn't add companies that are worth less than that to your portfolio

Quite frequently, the best investment to make is to double down on something that you already own

On Wall Street, just the opposite approach is used

If one holding advances to become a large part of their portfolio,

they typically sell parts of that company to invest in other companies, but this is madness

Trading away your largest holding just because it has come to dominate your portfolio is

very similar to saying that Barcelona should trade away Leonel Messi because he has become so important to the team!

Crazy!

According to Warren Buffett's right-hand man Charlie Munger,

not using probabilities for investing is like being a one-legged man in an ass-kicking contest.

You're giving away a huge advantage to everyone else!

When deciding how big you should bet you can use something called the Kelly Formula,

which you can learn about in my summary of the Dhandho investor

Takeaway number 3: Is focus investing super-risky??

Takeaway number 4: An alternative ..

Maybe I should elaborate a little bit ...

I bet you've heard from many different sources that, as an investor, one must diversify

Diversify diversify diversify

The one universal rule that idiots in finance know is diversification. It's the only free lunch. You gotta diversify.

Diversification is crucial ... and the more diversification you can get the better

Single stocks are a bad place to invest money ... You're much better off to be spread out and well diversified

And it isn't such a bad idea

Even Warren Buffett himself

admits that, for the know-nothing investor, it is a great option to periodically invest in index funds

These will give you a high degree of diversification and you are pretty much guaranteed to receive the average market returns

But the ambitious investor should ask himself this: am I satisfied with average returns?

Can I do better?

Let's look at why someone would diversify

Diversification means buying many different stocks so that a single one of them, or just a few of them,

can't have a large impact on the portfolio

And this is inevitably true - if you own 100 companies in your portfolio and you bet

1% of your capital in each of them,

you cannot lose more than 1% on any single company, even if this company ends up in the worst bankruptcy in history

If you own 20 stocks in a similar fashion, you stand to lose 5%

If you own 10 stocks, 10%, etc

The opposite is of course also true - in a portfolio with 100 companies, each representing 1% of the total,

you cannot gain more than 1% should any single one of the stocks in it double

20 stocks and you can gain at maximum 5%. 10 stocks and you can gain 10%

What diversification gives them is reduced volatility

Your portfolio will fluctuate

less and less the more companies you add to it, given that the stocks of these companies do not move in tandem, of course

But risk is not volatility!

If you portfolio fluctuates a lot, who cares?

Is this a bad situation?

Not necessarily, because it probably means that you can buy more of the great companies that you already own at bargain prices

Is this a bad situation then?

Well, few would question that, but it could mean that your companies are overvalued and that some of them should be exchanged for lower valued ones,

or it could simply mean that your companies are doing great

Risk is:

Not knowing what you are doing

If you add an additional 90 companies that you don't know much about to a portfolio of 10 companies,

which you do know a lot about (just for the sake of diversification) you have just increased your risk not decreased it

Not knowing enough about 90% of what you own, how can that possibly be a reduction of risk?

Risk will decrease the more knowledge you have, and you have the possibility of having more knowledge about your portfolio

the fewer companies that you have in it

As I said earlier:

Takeaway number 4: An alternative portfolio benchmark

Perhaps you noticed in the introduction, the portfolios that I presented

represents the earnings of Berkshire Holdings as a part of total earnings and not the market values of the holdings as part of the total

The reason for this is twofold:

Firstly, it was difficult creating these illustrations as it involved a lot of assumptions and guesstimates

It would have been even more difficult

if I tried to convert Berkshires wholly owned subsidiaries into market values

So yeah, the first reason is because I was kind of lazy

Secondly -

earnings is the ultimate yardstick of the intelligence investor

Warren Buffett says the following:

"The goal of each investor should be to create a portfolio

that will deliver him or her the highest possible earnings a decade or so from now"

As discussed in the last takeaway - focus investors will have portfolios which fluctuates a lot

To be able to handle this mentally, you must become a master bump ignorer

Take the returns of some of the greatest investors of all time - such as John Maynard Keynes,

Warren Buffett, Charlie Munger, Bill Ruane and Lou Simpson

Notice how they have performed compared to the S&P 500 over the years

Their returns have fluctuated a lot. Sometimes they've underperformed the market over several years!

But over the long run, their portfolios have had huge returns

One reason why they were able to stay the course

even during times of turmoil is because they

focus on the companies that they own and not the price that the market sets on these companies

One way to do this is to look at earnings instead of market values

Earnings will fluctuate much less, and over time, they will decide how successful you are as an investor

"The market may ignore business success for a while, but eventually, it will confirm it"

Takeaway number 5: The Warren Buffett principles

You've learned about how to concentrate your investment portfolio around great businesses, but what actually makes a superior business?

I've made a whole playlist on what Warren Buffett thinks about this subject that I will link to at the end of this video,

but here is a short checklist of some of his most important principles:

Business principles:

Do you understand the business?

Is the history of the business consistent?

Does the business look promising in the long run?

Management principles:

All the managers rational?

Are they honest with shareholders?

Do managers show independence of thinking?

Financial principles:

Focus on return on capital

Find out what the "owners earnings" are

Look for high profit margins

One dollar retained in the business must always produce more than one dollar of market value

Market principles:

What is the value of the business?

Use a margin of safety. Buy the stock at a price which represents a comfortable discount to the value of the underlying business

When you are trying to pick great companies on your own, there are two ways to go about this

You can go from left to right - first looking for great businesses

then considering the management, then the financials and finally the price

With this approach,

you only look at the price of a company,

for example, if you first confirmed that it's a good business with good management and good financials

The other approach is that you start with the financials, and then go from left to right

This approach might be quicker as you can sort companies out quickly using a financial database like

screener.co, CapitalIQ or borsdata.se

For more about Warren Buffett and his investing approach, head over to my playlist of Warren Buffett books. Cheers guys!