Joel Greenblatt: Which Is Better? A Concentrated Or Diversified Portfolio

Johnny HopkinsJoel GreenblattLeave a Comment

In his latest interview on The Investors Podcast, Joel Greenblatt discussed the benefits of running concentrated and diversified portfolios. Here’s an excerpt from the interview:

That was the very first test we did was that, but it also set off a light bulb, my partner, Rob Goldstein, and I in our heads, as soon as we …

We call that the not trying very hard method, meaning we just used crude metrics, crude database. We said, we know how to invest, we know how to do the work. These aren’t pieces of paper to us. These are ownership, shares of businesses that we’re actually valuing, and we actually know how to value businesses. What if we put a little effort in, could we improve on this? Of course, we did, and built a big research team and everything else. We really were just building it for us to see if we could put together a diversified portfolio of cheap companies and expensive ones, and see if we could come up with strategy that was also good.

It turned out so good, our research, that we ended up starting in 2009, taking outside money again. One of the discoveries we made was that we could actually, following the style, diversified portfolios on the long and short side, make more money with a diversified portfolio than a concentrated portfolio using the style. The reason for that is that when you have a concentrated portfolio, and concentrated, we own 300 or 400 stocks on the long side and 300 or 400 on the short side, choosing from the 3,000 largest, let’s say.

We made more money doing that than if we bought our 50 cheapest and shorted our 50 most expensive. The reason for that is those become much more volatile, and there are bad periods. If you think back to let’s say 1999 or 2000, you could really get in trouble just buying the cheapest and shorting the most expensive. Eventually it works, but if you’re going long, short and put on leverage, that’s pretty dangerous. One of the reasons why an insurance company would insure five people, no matter what kind of underwriting they do, how much research they do on how healthy you eat and what your medical stats are, some people step off the curb at a bad time and ruin all those numbers.

You can tell I don’t sell insurance. It turned out that you actually made more money over time with a diversified portfolio, and there’s nothing wrong with what I was doing, but with a concentrated portfolio, we were doing that for a long, long time. It was a lot of fun. We were good at it. This was fascinating to us, running a big research team, following a lot of companies, trying to be right on average was another way to make money. It was maybe a smoother ride. It didn’t come with every two years losing 30% or 40% of your money.

I still teach the other method of being concentrated. I still teach my kids that method. I think it’s a great way to make money, and they’re not better or worse. They have different sort of … It’s different strokes for different folks. If you can’t take the pain and you’re too concentrated, you’re gonna quit after a bad period, then you’re not really going to collect at the end of the day. For most people who don’t know how to value companies, I wouldn’t say concentrating like that, unless you really know what you’re doing is a good strategy.

This is a more widespread strategy for more people, maybe a smoother ride. They’re both great. They’re both full-time jobs, to really do a good job drilling deep on just a handful of companies, or covering a wide universe of companies. They’re both full-time jobs. People ask me this question all the time, which is better, or why did you switch? It’s just different ways to make money. I was fascinated by one way for a long time. I showed that it could be successful. Then we really were pursuing this more diversified strategy just because it was fun and it was fascinating.

It turned out, when we learned that we could make more money, we actually ended up with higher, slightly higher returns, but a lot less volatility with a more diversified portfolio following the strategy, that it didn’t hurt us to take outside money, and it was a very expensive operation because you need a lot of computer wizards and you need a lot of research people to do the actual fundamental work. So, it made sense for us to take outside money, but we went about that backwards. That wasn’t our goal. Our goal was to do this for ourselves. Also do something different, see what we learned.

All the principles are still the same. Nothing’s really changed. Just sort of portfolio strategy. I love them both, depends who you are. It depends what your risk tolerances are and what you enjoy doing, I would say. They’ve both been fun journeys. I love both methodologies. I wouldn’t read anything into it that we’re not doing that concentrated investment. If I went to start again, I’d go do that again.

You can listen to the entire interview here:

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