{"id":106389,"date":"2023-06-20T12:40:00","date_gmt":"2023-06-20T16:40:00","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=106389"},"modified":"2023-06-27T15:12:46","modified_gmt":"2023-06-27T19:12:46","slug":"focus-investing","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/focus-investing\/","title":{"rendered":"Focus Investing vs. Modern Portfolio: Warren Buffett&#8217;s Choice"},"content":{"rendered":"\n<p>What&#8217;s focus investing? How is it different from <a href=\"https:\/\/www.shortform.com\/blog\/markowitzs-theory\/\">modern portfolio theory<\/a>? Which approach does Warren Buffett take?<\/p>\n\n\n\n<p>According to Robert G. Hagstrom, Warren Buffett departs significantly from the mainstream when it comes to portfolio management. While most investors diversify their portfolios broadly to minimize volatility, Buffett focuses on a select handful of stocks to maximize his chances of above-market returns.<\/p>\n\n\n\n<p>Read more to learn about focus investing and why Buffett prefers it to the modern portfolio approach.<\/p>\n\n\n\n<!--more-->\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-focus-investing\">Focus Investing<\/h2>\n\n\n\n<p>To see the merits of focus investing, it\u2019ll help to first discuss the main alternative: diversification. Hagstrom notes that investors traditionally prefer diversified portfolios because they supposedly minimize risk\u2014after all, if you have 1,000 stocks represented in your portfolio and one lone stock takes a nosedive, it\u2019s unlikely to cause a catastrophic loss. By contrast, if you only have five stocks in your portfolio, one plummeting stock could cause an outsized loss.<\/p>\n\n\n\n<p>However, Hagstrom points out that Buffett is opposed to diversification for one simple reason\u2014it can only lead to mediocre results relative to the market\u2019s average returns. After all, the more diversified your portfolio is, the more closely its returns will mirror those of the stock market.&nbsp;<\/p>\n\n\n\n<p>Not content with mediocrity, Buffett instead prefers a portfolio consisting of around 10 stocks that he deems exceptional. To show that this approach is most likely to generate above-market returns, Hagstrom cites a statistical simulation showing how hypothetical portfolios of different sizes performed over time. This simulation included 3,000 portfolios of only 15 stocks\u2014the focus group\u20143,000 portfolios of 50 stocks, 3,000 portfolios of 100 stocks, and 3,000 portfolios of 250 stocks. Hagstrom notes that, of the focus portfolios, over 25% beat the market over a sample 10-year period; by contrast, only 2% of the portfolios with 250 stocks beat the market over that same time span.<\/p>\n\n\n\n<p>Admittedly, Hagstrom concedes that because smaller portfolios are more <em>volatile<\/em>\u2014meaning they have greater swings in value\u2014they\u2019re also much more likely to deliver <em>below-average <\/em>returns. However, he suggests that investors can avoid this possibility through Buffett\u2019s savvy stock selection, which he deems far less likely to yield subpar returns.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\" id=\"h-focus-investing-vs-modern-portfolio\">Focus Investing vs. Modern Portfolio<\/h3>\n\n\n\n<p>Buffett\u2019s focus investing is diametrically opposed to the orthodox investing approach in academia\u2013<em>modern portfolio theory<\/em>. In particular, <strong>Buffett rejects modern portfolio theory\u2019s understanding of market efficiency and risk.<\/strong><\/p>\n\n\n\n<h4 class=\"wp-block-heading\">View #1: The Efficient Market Hypothesis<\/h4>\n\n\n\n<p>As Hagstrom relates, the cornerstone of the modern portfolio is <a href=\"https:\/\/www.shortform.com\/blog\/the-efficient-market-hypothesis\/\">the efficient market hypothesis<\/a> (EMH)\u2013the thesis that stock market prices perfectly reflect all available information about a given company, meaning all stocks are fairly priced. Consequently, proponents of EMH reason that investing ultimately boils down to luck, since no amount of analysis will reveal insights that aren\u2019t already baked into a company\u2019s stock price.<\/p>\n\n\n\n<p>(Shortform note: Although Hagstrom and other investors write as if EMH is one simple thesis, <a href=\"https:\/\/www.investopedia.com\/ask\/answers\/032615\/what-are-differences-between-weak-strong-and-semistrong-versions-efficient-market-hypothesis.asp#:~:text=Though%20the%20efficient%20market%20hypothesis%20theorizes%20the%20market%20is%20generally,semi%2Dstrong%2C%20and%20strong.\" target=\"_blank\" rel=\"noreferrer noopener\">economists typically distinguish between several forms of EMH<\/a>. For instance, only the <a href=\"https:\/\/www.investopedia.com\/terms\/s\/strongform.asp\" target=\"_blank\" rel=\"noreferrer noopener\">strong form of EMH<\/a> states that <em>all <\/em>information, public or private, is baked into stock prices. By contrast, the weak form of EMH specifies only that <a href=\"https:\/\/www.investopedia.com\/terms\/w\/weakform.asp#:~:text=Weak%20form%20efficiency%20claims%20that,efficient%20market%20hypothesis%20(EMH).\" target=\"_blank\" rel=\"noreferrer noopener\">all <em>past <\/em>financial information is baked into stock prices<\/a>, a more modest claim.)<\/p>\n\n\n\n<p>Buffett rejects EMH, arguing that many investors\u2014himself included\u2014have used focus investing to generate above-market returns, and these returns aren\u2019t just the product of luck. These investors, including Charlie Munger, Bill Ruane, and Lou Simpson, all used similar approaches to investing, centered around Graham\u2019s strategy of finding undervalued stocks. And, rather than claiming that the success of this shared approach is a coincidence, Buffett finds it much more believable that EMH is simply mistaken.<\/p>\n\n\n\n<p>(Shortform note: While Hagstrom claims that Buffett\u2019s success could only be chalked up to luck if the EMH were true, another explanation exists: EMH <em>wasn\u2019t <\/em>true when Buffett began investing, but it\u2019s true <em>now<\/em>. In other words, we might respond that the market<em> was <\/em>less efficient in the 1980s and 90s, allowing Buffett to find an investing edge through in-depth analysis, but it\u2019s now efficient enough that his analysis is pointless. Indeed, experts argue that <a href=\"https:\/\/www.sciencedirect.com\/science\/article\/abs\/pii\/S0378426614004002\" target=\"_blank\" rel=\"noreferrer noopener\">the US stock market became significantly more efficient between 1998 and 2010<\/a> alone, making it plausible that the market was less efficient when Buffett began investing.)<\/p>\n\n\n\n<h4 class=\"wp-block-heading\">View #2: Defining Risk as Volatility<\/h4>\n\n\n\n<p>Because modern portfolio theory holds that investing boils down to luck, it defines risk as volatility, since the more volatile your portfolio is, the more likely that you\u2019ll lose money. Buffett, however, has a different conception of risk when investing: According to Hagstrom, he defines it as the possibility that you\u2019ll be left with less purchasing power than you began with.&nbsp;<\/p>\n\n\n\n<p>(Shortform note: Because portfolios with more stocks spread across different industries are less volatile, modern portfolio theory contends that diversified portfolios are also less risky since they minimize volatility. However, it\u2019s worth mentioning that even the most diversified portfolios can be volatile because the market <em>itself <\/em>is volatile; for instance, the stock market typically experiences <a href=\"https:\/\/awealthofcommonsense.com\/2022\/01\/how-often-should-you-expect-a-stock-market-correction\/#:~:text=This%20means%2C%20on%20average%2C%20the,every%207%20years%20%2820%25%2B%29&amp;text=a%20crash%20once%20every%2012%20years%20%2830%25%2B%29\" target=\"_blank\" rel=\"noreferrer noopener\">at least one 30% annual drop in a given 12-year period<\/a>.)<\/p>\n\n\n\n<p>Hagstrom explains that, for this reason, Buffett emphasizes the importance of patience to mitigate risk. After all, if you\u2019ve selected an exceptional stock to invest in, it\u2019s highly likely that its stock price will rise given enough time. By contrast, even if you invest in an exceptional company, your risk will be high if you only hold it for one week since the stock market experiences short-term ebbs and flows.<\/p>\n\n\n\n<p>(Shortform note: In stark contrast to Buffett\u2019s patient approach to investing, some investors engage in <em>day trading<\/em>\u2014<a href=\"https:\/\/www.investopedia.com\/articles\/trading\/05\/011705.asp\" target=\"_blank\" rel=\"noreferrer noopener\">purchasing and selling securities within a single day<\/a> in hopes of profiting from daily price fluctuations. But experts warn that <a href=\"https:\/\/www.investor.gov\/additional-resources\/spotlight\/directors-take\/thinking-day-trading-know-risks#:~:text=you%20at%20first.-,If%20a%20stock's%20price%20or%20the%20market%20moves%20in%20the,substantially%20more%2C%20than%20initially%20invested.\" target=\"_blank\" rel=\"noreferrer noopener\">day trading is exceedingly risky<\/a> since these fluctuations can generate quick losses.)<\/p>\n","protected":false},"excerpt":{"rendered":"<p>What&#8217;s focus investing? How is it different from modern portfolio theory? Which approach does Warren Buffett take? According to Robert G. Hagstrom, Warren Buffett departs significantly from the mainstream when it comes to portfolio management. While most investors diversify their portfolios broadly to minimize volatility, Buffett focuses on a select handful of stocks to maximize his chances of above-market returns. Read more to learn about focus investing and why Buffett prefers it to the modern portfolio approach.<\/p>\n","protected":false},"author":9,"featured_media":85985,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[81,31,33],"tags":[1073],"class_list":["post-106389","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-economics","category-money","category-people","tag-the-warren-buffett-way","","tg-column-two"],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v24.3 (Yoast SEO v24.3) - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Focus Investing vs. Modern Portfolio: Warren Buffett&#039;s Choice - Shortform Books<\/title>\n<meta name=\"description\" content=\"Warren Buffett rejects modern portfolio theory\u2014the orthodox investing approach. 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