Last week, a friend and I were musing over whether we would ever put 100% of portfolio NAV into one security. While pondering this question, my mind recalled the following passage that Jeremy Grantham wrote in his 2010 2Q letter on global warming:
“Skeptics argue that this wide range of uncertainty lowers the need to act: “Why spend money when you’re not certain?” But since the penalties rise hyperbolically at the tail, a wider range implies a greater risk (and a greater expected value of the costs).”
In other words, there are those who believe that the probability of catastrophic effects of global warming actually occurring are extremely low, and therefore are against prevention measures. However, if they are wrong and the catastrophic effects of global warming do occur, the consequences are so prohibitively high that humans are unlikely to survive to change their future behavior.
Bear with me, there’s a weird parallel here. Let’s play a game of word replacement.
Excessive portfolio concentration, such as putting 100% of portfolio NAV into one security, usually occurs because the investor believes the probability of a worst case occurring is extremely low. However, if the investor is wrong and the worst case does occur, the consequences are so prohibitively high that the investor (and his/her fund) is unlikely to survive to change future sizing behavior.
So my answer to the question at the very beginning was ‘NO’ I would not put 100% of portfolio NAV into one security because the potential consequences include not only destroying your capital base and trackrecord, but also your reputation.
Interestingly though, if not 100%, what about 95%? 80%? 60%? Where is the cut off for concentration so that it is no longer considered “excessive?”
Update: A Reader, who has spent many years allocating capital and speaking with fund managers, emailed me after reading this article and provided the following piece of interesting information, food for thought:
"My experience over time is whatever a manager picks he always always always lowers with experience...."