As an investor most people are investing in the stock market based on the buffet meal system unknowingly. Very few investors are investing based on the concept of A la carte!
Before Effect
Now let’s imagine you have gone to a restaurant to have lunch or dinner. And the restaurant offers you an A la carte as well as buffet meal system. Now Restaurant tells you that if you go for buffet meal system at a particular price, we will provide you 2 kinds of soups, 2 types of mocktails, 4 types of starters, 2 live counters, 4 main course, 3 types of breads, dal rice, and 4 types of desserts and 2 types of ice cream at the end and that too unlimited. Most people will get excited and will go for the buffet system. All those kinds of big course meals will excite you about having each and everything at the table that also for a fixed price.
Same way in stock market when investors are trying to make a portfolio, most investors get excited for having all kinds of companies in the portfolio, investors are looking to accommodate companies from each and every sector no matter if a particular sector is under the bad phase, many times investors are looking to accommodate 2-3 companies from the same sector, thinking they can’t afford to miss any of those. Many times investors are applying for IPOs and when they get allotment they feel, they can’t afford to sell these newly listed companies, its same like the buffet meal system where stomach is happy behind the psychology of having bite of each and everything available on the table, same way in investing while making a portfolio investor is happy behind the psychology of having most companies in the portfolio so they feel happy thinking that no matter what happens some companies are to perform very good and in this thinking process portfolio ends up accommodating 75-200 stocks.
After Effect
Now let’s go back to our lunch or dinner date which we were enjoying at the restaurant with a very happy stomach in the beginning while choosing the buffet system. Now you took an empty plate and bowl and went for the killing! I mean you went to enjoy wholesome food with a lot of excitement within, now initially when you start having soups, starters you feel so delighted and feel proud of your decision to go for the buffet system. And as you keep consuming different varieties of food, till the starters itself, your stomach starts feeling full! But yes, at that time only stomach is full not the mind, your heart wants more (Yeh dill maange more) as many items are still pending to taste, and mind also wants to taste those items again which tasted very good. If I say in Hindi “पेट भर गया है, लेकिन मन नहीं भरा है”.
So, our mind wants to try new items as well as wants to try tasty items once more. And in this process, we forget about our stomach which was very happy initially but now our poor stomach is in a complete mess as we are just listening to our mind, and our mind is satisfied only once we have all the items! Then we remember our poor stomach, which is in a complete mess now and yes, we start feeling uneasiness with stomach, but by then it’s too late to realize that! After eating the final thing i.e. after eating the ice cream, on way back to home we discuss with our family that we should have gone for the A la carte, what a mess we did to our stomach! And all agrees to it. Then we start realizing the benefits of Ala carte like having concentrated meal, all meals are hot and live, we get everything served on the table, we can feel like we have eaten something good with a decent portion whereas in buffet system we have everything, but everything we eat in small portion and at the end feeling is a mixed feeling.
Same way, we as investors while designing the portfolio, we are so excited, we just start adding all those companies which we believe are good, we keep accumulating different companies. Whenever we hear about a good company, we just add that without selling any existing company. It’s like if there is any good company in the town, that must be part of our portfolio, after all we can’t afford to lose that company from our portfolio, we just want every damn good thing to be part of our portfolio, and once we have all those companies with company count of 75-200 companies we start believing we have achieved something really great and we just start waiting to see our fortunes turning into gold.
But to the surprise of such investors, over a period of years their portfolio becomes buffet of so many companies, where everything looks good from far but when you come closer and see the return, you will see a mediocre return which is even less than the index return itself, and after all those years of time and effort, we realize it would been better if we would have just invested in index (nifty bees) instead of this portfolio which is nothing but a buffet of many companies, we would have been on a better position. All those years of time and effort goes in vain! Basically, its same like buffet example where stomach was in a mess, here portfolio is in a mess!
Now let us see the reason behind this.
When we have so many companies in portfolio, weightage in most companies will be around 1% and even lower in some companies and due to that underperformance or out performance of a particular company, will not affect much the overall performance of the portfolio. Let’s say for example your portfolio is having 100 companies and altogether for these 100 companies you have invested total ₹10 lakhs, now if you invest equally in all companies, you will be able to invest ₹10000 in each company and weight in each company will be 1% and if you don’t invest equal amount in all companies, then some companies will end getting weight more than 1% and some even less than 0.5%.
Now suppose one of the portfolio companies out of 100 companies becomes 10x in 4-5 years. so 10000 invested will become one lakh, company level return will be 1000% but on overall portfolio level it will give a return of only 10%, and that is the reason why overall portfolio gives a mediocre performance because every company will not become 10X in 4-5 years, in fact some of them will give loss, some of them will be flat and some of them will give single digit return, while handful of companies will give higher double digit return.
When you have 100+ companies, tracking of business and financial performance becomes almost impossible, a normal human being cannot read more than 100 profit and loss account statements every quarter, and even if someone reads those, a person can not remember all the performances for long time. Concentration in the portfolio will always give comfort and better clarity, we have limited companies to track regularly, we have sizable portion of weight in each company so if some companies become multibaggers our portfolio will shine like a star. A sizable quantity of shares of all portfolio companies will help in achieving a higher double digit CAGR return. And that will be possible only if we have a maximum of 15-22 companies in the portfolio. We can gather good quantities only if the number of companies in our portfolio is limited.
We as investors will have to change the mentality of having everything available in the town. We must be very choosy. Like one of the great investors Late shri Rakesh Jhunjhunwala ji used to say, “we don’t need to attend every party in town.” We should attend limited parties but with a bang! For example, there are more than 4150 actively listed companies in India and out of those 400-500 must be very good companies, but we can’t have them all in our portfolio. 15-22 companies should be our priority and the rest of all those 4100+ companies should be the opportunity cost for us.
Just to add little fun and one more relatable example, when you visit your friend or relative next time, tell them you have bought sweet for them from a famous sweet shop, and it’s a very premium and expensive sweet and you have bought a premium sweet for them which is selling at ₹2000+ per kilograms. Your friend/relative will feel happy, now once your friend or relative is very happy, tell them while handing over the packet of sweet that you have bought just 50 grams of that premium sweet for him or her! Now you can imagine the facial expressions of your relative/friend who was once a very happy person. Same way in our portfolio of 100+ companies we are holding many 50 grams of sweets against 1 kg in every company! So, by now we have understood that concentration of things and focus makes life better in many ways. (By the way the sweet example was just for fun and being relatable, don’t try this sweet example with your loved ones and if you try then try at your own risk. Now jokes a part, let’s go back to our core theme of portfolio designing.)
Continuing with our initial example, space in stomach is limited, same way our capital is limited as per our size of capital individually. So, we should utilize our available capital in the most efficient way by choosing limited number of high quality companies, and we should have minimum 3% weight in a particular company and we can keep high weight like 5-7-10-12% depending upon the strength of the company and our conviction on the company, like the great investor Mr. Ramesh Damani ji says, once you have identified a great company and you have a very high conviction, buy a truck load quantity of that company as per size of your capital. That means if you have found a great company, and you have very high conviction on that company then one should buy that company with a decent high weight. So minimum 3% and max 10-12% should be the ideal weight of different companies in portfolio. Investors who are looking for decent return with not very high-risk capacity should not have more than 10-12% in any company to mitigate risk of over concentration, yes, we need the concentration in the portfolio but over concentration is always very risky. Same way we should have minimum 3% weight in a particular company in the portfolio to have a decent portion.
Thanks and Regards
